The value of any business is simply defined as the total cash that a business will throw off during its existence. The DCF Model, as the name implies, shows what the value of a company's future cash flows would be worth today if the cash flows were discounted back to the present time for the company in question. The DCF Model is certainly not a perfect valuation tool (as it is difficult to accurately predict at what rate a company will grow its cash flows at in the future), but it can provide a very useful valuation estimate if the users uses conservative assumptions. The user of this form should keep in mind that the intrinsic value that is produced is only as good as the numbers put into the model. If you assume unrealistic growth rates (or terminal value) you will get an unrealistic intrinsic value result.

Who uses this valuation method? I have listed several firms that I respect below:

1. The Clipper Fund uses the discounted cash flow method in their valuation process as is evident in this quote: "Our investment approach is very research intensive and includes meeting with management and preparing detailed valuation models for each company followed. The valuation models calculate the intrinsic value which is based on private market transactions and discounted cash flow valuations."

2. Longleaf Partners also use the discounted cash flow method as one means to determine the intrinsic value of a company. They "…determine the company's ongoing value based on its ability to generate free cash flow after required capital expenditures and working capital needs. We calculate the present value of the projected free cash flows plus a terminal value, using a conservative discount rate.

3. Mr. Warren Buffett has this to say in his 1992 Berkshire Hathaway annual report concerning the DCF valuation method: "In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

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Initial Cash Flow
The initial cash flow should be what the company really earned in the year being examined. The growth expectations entered into the form should reflect your judgment on what rate owner earnings will grow in the future. Owner earnings, a concept Mr. Buffett uses that is equivalent to the amount cash that the investor could take out of the business, is defined as "reported earnings plus depreciation, depletion, and amortization, and certain other non-cash charges… less the average annual amount of capital expenditures… that the business requires to fully maintain its long-term competitive position and its unit volume. If the business requires additional working capital to maintain its long-term competitive position and unit volume, the increment should also be included."

Terminal Growth Rate
The rate that you expect the owner earnings will grow at for infinity.

Discount Rate

Textbook Definition: The discount rate is calculated by taking a risk-free return (the yield on 30-year US Treasury Bonds) and adding a risk premium to account for the uncertainties involved in holding equities. I like to think of the discount rate as the rate I would expect to earn if I was able to invest in a company at its intrinsic value. For example if I wanted to earn a 15 percent return on my investment I would use 15 percent as my discount rate. An investor would earn a 15 percent rate of return if the investor was able to purchase the investment at its intrinsic value.

Here is a collection of quotes by Mr. Warren Buffett on the issue of what discount rate to use:

"We don't discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate."

At the 1998 Berkshire Hathaway annual meeting, Mr. Buffett defined intrinsic value as follows: "In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value - in our case, at the long-term Treasury rate. And that discount rate doesn't pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses."

At the 1994 Berkshire annual meeting Mr. Buffett stated that "In a world of 7% long-term bond rates, we'd certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we're willing to play. We have to feel pretty certain about anything before we're even interested at all. But there are still degrees of certainty. If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we'd use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises."

Scenario Analysis

This section of the form allows the user to see what the expected intrinsic value of an investment would be if several difference valuation scenarios were considered. The user can run up to four separate valuation scenarios, note what the intrinsic value result was for each individual valuation scenario, and enter those results in the intrinsic value column of the scenario analysis box. The user then enters the probability that they think each scenario has of occurring. The expected intrinsic value is simply the sum of all these scenarios after each individual scenario has been multiplied by the scenario likelihood.

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