My New and Simple Method of Calculating DCF Growth Rates

Now here’s a more thorough answer to why I’ve changed things up with the valuation models.

But first…

The Problem with Bottoms Up Fundamental Models

Growth is a necessary evil.

There’s no way around it because if you don’t factor in growth, nearly everything is overvalued except for small, ugly cigar butts.

Growth is only evil because it’s something that no one can accurately pinpoint a growth rate as it’s in the future.

But the US has a great future lying ahead.

Sure the current state of the economy and government may be messed up, but don’t take my word for it.

Let’s ask Buffett what he thinks;

The dynamism embedded in our market economy will continue to work its magic. Gains won’t come in a smooth or uninterrupted manner; they never have. And we will regularly grumble about our government. But, most assuredly, America’s best days lie ahead.

The big change to the OSV analyzer and the way I value stocks has changed because now I place more importance on growth than I used to.

Don’t misunderstand that I didn’t appreciate growth before and now all of a sudden I’m a growth investor.

No.

What I’m saying is that my analysis and valuations models were too backwards looking and that has changed.

Until this new version of the stock analyzer, I took the firm stance of applying the idea that;

In the business world, the rearview mirror is always clearer than the windshield. – Warren Buffett

I still hold to this principle when analyzing the financial statements to get into the fine details of how consistent and strong a company is.

After all, managers lie but the numbers don’t. So financial analysis is vital to understand the operating history of the company from a numbers point of view.

But with valuation, it’s different.

Here’s what I mean when I run a DCF on AAPL of the before growth calculation method and after.

Before:

Using Past Performance to Project Forward

After:

Enhanced Growth Estimate

Apple definitely isn’t going to grow as fast as it did in the past. So the 25% growth based on its past performance isn’t realistic.

Even though I smooth out the big ups and down, 25% is too much to ask from the biggest company in the world going forward. But the 13% growth rate is much more realistic and achievable.

Is it 100% correct?

Of course not, but…

It is better to be approximately right than precisely wrong – Warren Buffett

Getting to the Point: How is Growth Calculated Now?

So how is the new growth rate calculated?

It’s the median of the following 4 factors:

• Next Year Growth
• Long Term Growth
• Next 5 Year Growth
• Industry Long Term Rate

Notice that these are forward looking numbers so there’s more logic to the valuation.

I’m no longer using past numbers to calculate a growth rate to project the future. That would be like walking backwards.

Instead, I’m now looking over my shoulder to check what’s behind me as I walk forwards.

By using the above numbers, it makes it easier to value

• growth stocks
• companies that have slowed down
• and cyclical companies

Does it Work?

But here’s the con, and an area that I’ll be thinking more about.

The above numbers are based on earnings growth.

Not FCF growth.

An earnings growth of 15% doesn’t translate to a FCF growth of 15% and that’s why EPS has also been added to the DCF model.

I’ll explain the reasoning behind the new addition in another post, but as I struggled with this idea, I kept coming back to the purpose of valuation and how people view it.

My conclusion is that valuation exists purely so that you and I know how much we should pay for an asset.

In the stock market, that’s the stock price. And if using EPS growth rates help provide a more consistent and accurate valuation than FCF in many cases, there is certainly no harm against using it.

You can see the exact calculations and how the new and enhanced DCF valuation works if you are an Old School Value member.

The 20% promotion is on until this weekend, so if you’ve been on the fence because of the upfront investment, lock in your membership at a heavily discounted rate.

You’ll also easily make your money back using the OSV analyzer with these 3 methods:

1. Choosing a quality stock with the analyzer will pay off your initial investment easily
2. Avoiding a value trap, horrible idea or selling a bad holding is the same as making money
3. Value your precious time. The amount of data access and speed of research will help you focus on being productive and analyzing the right stocks and ignoring the noise.

If any of the above makes sense to you, be sure to subscribe by this weekend.

I’ll be going over the reasoning behind the inclusion of EPS as a “cash flow” input in the DCF next time so stay tuned.