Practicing DCF modeling for a company I am interested in, and I think I effed this DCF up. After going down to calculate my TEV and subsequently my EV, I checked CapitalIQ on what consensus values were. What was reported was ~18B, while I got ~6B...... I know this stock is pretty notorious for being overvalued, but I think this may be a substantial error on my part....
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Try and share photos of your DCF if you can to provide more info
Can take a look if you post a link.
Simple check: if you do a gordon growth terminal value calculation on this year's results, you have a reference point for your valuation. As you project growth (of FCF) most likely, your valuation should be higher than this reference point.
Maybe your discount rate is wrong? Or your company doesn’t achieve steady state at the end of the projection period? Maybe you calculate FCF wrong or don’t include all the items in the NWC? Maybe your capex assumption are too aggressive? Or your perpetual growth rate/exit multiple is wrong?
Besides, DCF is a subjective valuation that’s driven by your assumptions. There is no right or wrong answer if you can defend your assumptions and the fact that share price that came from the DCF doesn’t match with current share price doesn’t matter imo. Unless you’re in IB and your MD specifically tells you what should be the output of your model.
Are you supposed to achieve steady growth at the end of the DCF projection period? Say you are using a perpetuity growth rate of 2% but the business growth is say double that or even more by the end of your projection is this incorrect? Also if this is incorrect, how should you target steady growth? Is this through revenues or through UFCF? And should this steady growth be represented through a per year growth rate (say a growth rate closer to 2% in the last 2 periods of ur projection period) or through a CAGR?
Easiest way to know whether you made a calculation error or if you are running wildly different assumptions would be to check the PGR / exit multiple used in some of the reports consolidated into the consensus figures on CapIQ
There are a few things to consider.
1) You’re most likely making a mistake with the discount rate. The discount rate will typically make the biggest impact on the model because it affects every single cash flow + the terminal value. 2) This is less likely to have a huge impact, but it will have a noticeable impact. What’s the timing of the cash flows? Is it a cyclical business where they make most of their money throughout the year or should you use a half year convention because it’s non-cyclical? 3) Are you calculating capital expenditures and NWC correctly? It’s easy to do a blanket statement and say these are a % of revenue but full time analysts will use other methods that make it more accurate (based on company growth projections and stuff). 4) So you’re trying to back into equity value after calculating enterprise value - did you subtract anything that you shouldn’t have?
And finally
5) What if you really did calculate everything and it IS extremely overvalued? If you look at Nikola, they had a $30bn market cap in their first week and they only barely just broke ground on their factory. With the rise of the retail investor we are experiencing wildly inflated market caps, and it’s possible that many of these companies don’t deserve a fraction of the value they have according to a DCF.
Also everything in a DCF is completely up to opinion. Maybe make a sensitivity analysis and see what the TEV would be with different assumptions.
Turn your equity value into a per share price and then compare your current model + the updated one to the prices that analysts have put out. If you look up “Company ABC target stock price” then you’ll likely find the target price for all of the analysts who actively cover it. It’s possible that a consensus for a $20 stock price can be extremely skewed, for example: you only have 4 analysts who cover it - 3 with a $10 target and 1 with a $50 target. If you’re closer to the $10 than the $50 then I’d say you’re probably on point in your assumptions.
could you explain when and why you should use a half year convention in a dcf?
Of course. I’ll explain a concept then answer the question directly.
Time value of money = why. Money today is worth more than the same amount of money 2 months from now because if I give you $10 and you invest it, you could maybe have $15 instead. So if I wait 2 months to give you $10, you’ve effectively missed out on $5. This is your opportunity cost.
The discount rate is what accounts for this opportunity cost - it represents the return that investors/stake holders expect if they put their money into the firm.
——
If a company makes all of its money at year’s end, it’s accurate to use a full year DCF convention. This is for companies that are markedly cyclical - maybe the company only makes sunscreen and it’s cloudy for 9 months out of the year but blazing hot for 3 months each year. The company isn’t getting steady cash flow throughout the year - the cash flow is all coming at one point in the year and should be discounted at the end of the year. This is true for companies that gain all of their money in March even - maybe it’s January and your first year’s cash flows are worth more (read more about stub periods later), but after that you have to wait a whole year for more cash flow.
Most people are inclined to wear underwear throughout the year. If we used a normal DCF convention for non-cyclical companies like underwear distributors then we’re saying they make all of their money at a single point in the year, and that is at the end of the year. This would make the company worth less because the cash flows would be inaccurately discounted.
If we wanted to be extremely accurate then we would actually discount each day’s individual cash flows accordingly. This would be extremely tedious for investment bankers and would likely lead to much confusion and many mistakes - imagine trying to project and discount the cash flows for 5 years, all 365 days of each year.
So for companies that are non-cyclical, we need to discount their cash flows but we can’t discount them at the end of the year (the value would inaccurately be worth less) and we can’t discount them by each day (that would be tedious and likely inaccurate too).
So we use a half year convention. If we gain $1mm steadily throughout the year then it should be worth about the same as if we earned it all halfway through the year (discounted cash flows at the end of the year would average out with the cash flows at the beginning of the year to be worth about the same).
Hope this helps.
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