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Discounted Cash Flow (DCF) Analysis for BEGINNERS - How to Value a Stock Using Tesla as an Example - YouTube
Channel: rareliquid
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Today I'm going to walk you through the
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most fundamental valuation analysis
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called the DCF to equip you with the
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knowledge you need to value stocks
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What's up everybody my name is Ben and
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welcome to rareliquid a channel for
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tech investing and career advice
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Today's agenda looks like this. First,
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I'll provide a conceptual overview of
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the DCF,
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I'll then talk about why DCFs are
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important and when to use them,
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then I'll go over how to do a DCF and
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four key concepts,
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and lastly I'll show you a DCF using
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Tesla as an example
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Just to let you know in advance, this is
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not going to lead to a buy or sell
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decision for Tesla using
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a DCF that's not really the purpose of
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this video, the video is more to educate
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people on how to do
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a DCF and so sorry if that's what you
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came for but
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that's not hopefully what you're staying
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for. The DCF is not really a hard
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analysis
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but it is something that has a lot of
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parts to it that will take some time to
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explain so this is going to be part one
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of a many part series for the DCF and
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you can check
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a playlist on my channel called DCF
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videos and
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for all the videos in the future that
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will be related to DCF valuation
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analysis
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If you've been a loyal follower to this
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channel, first of all thank you
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and you probably have been realizing
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that I've been branching out into a ton
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of different topics like investment
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banking, crypto,
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stocks, and I keep everything organized
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as playlists on my channel so if you
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ever want to dive deep into a certain
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topic,
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check out the playlists on my channel
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I'll leave a link to it also in my
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description below
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Lastly, in case you are new here, all of
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the things I'm about to tell you come
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from my experience from working as an
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investment banking analyst at JP Morgan
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for a few years so
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that's where all of the knowledge will
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be really coming from and the
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experience and instruction and training
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that I received from
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banking is what I'll be using to kind of
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teach you guys about DCF
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Alright with that said, let me go over
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the conceptual explanation of a DCF
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Just in advance to let you know I'm
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going to be using a lot of words for the
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next 10,
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15 minutes or so to explain what a DCF
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is and then towards the end of the video
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you're going to see a lot of numbers
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associated with a lot of concepts that I
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provide you
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so make sure to stick through the whole
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video and try not to skip around if you
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have the time because everything is
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going to connect well together
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Let's first start off with something
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like a textbook definition
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A Discounted Cash Flow analysis is a
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valuation methodology that measures the
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intrinsic value of a company
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based on the present value of its future
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free cash flows
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If this is all new to you this probably
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all sounds like nonsense, so let's break
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down the three important concepts in
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this definition
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First intrinsic value. This just simply
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refers to a company's true standalone
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value based on its ability to generate
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cash rather than comparing it to other
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assets
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Intrinsic valuation compares to relative
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valuation which I made a video about if
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you want to check that out
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but basically relative valuation is
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when you compare one company to another
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set of companies
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to obtain valuation information while
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intrinsic valuation is you're only
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looking at that one company,
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creating a model, looking at the
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financials in order to get to evaluation
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Just to really hammer this point home
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let's use a bicycle as an analogy-
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let's say that you have a bike and
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you're trying to figure out what the
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value of it is
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Relative evaluation is where you would
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get the bike and compare it to other
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similar bikes at a bike store
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see what those bikes are selling at and
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then you can get a good sense of what
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your bike should sell at
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Now let's say you're getting this bike
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not for fun but only for work and you're
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trying to see what is the
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value of what I should pay to make sure
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that it's worth really buying this bike
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and so let's say you're using it for
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Postmates
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only, and you realize that over the next
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few years you can use the bicycle
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to earn something like a thousand
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dollars in cash. And so you wouldn't want
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to spend anything above
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a thousand dollars because basically
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then you would kind of lose money
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but if you were spending let's say $500
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for
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the bike then that would be worth it
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because you'd be able to profit $500
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over the next few years. So that's really
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kind of the core of intrinsic valuation
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really just looking at a company,
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how much cash can it get generate, and
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after I do my model,
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is the value of the company that I can
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currently buy it for or the stock
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I can currently buy is that lower than
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what it's trading at?
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And if so then it'd be a purchase if not
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then you would not want to buy it or
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sell the stock
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Second, let's talk about present value
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and this really
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just refers to the concept that a dollar
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today
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is worth more than a dollar tomorrow. I
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think thinking about this concept
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actually is more helpful with
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larger numbers so let's say that someone
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offered you
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one million dollars today versus one
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million dollars
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50 years from now and you had those two
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options which one would you take. Besides
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the fact that you probably just want a
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million dollars right now instead of
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when you're a lot older
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the fact is that you can use that one
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million dollars today and
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starting tomorrow just put it into the
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market and earn a return over time and
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so that's basically why
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a dollar today is worth more than a
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dollar tomorrow
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Just to crystallize this a little more
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let's say you invest that 1 million
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dollars into the stock market for 50
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years
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and get a 1 or 5 percent or 10% annual
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return
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and you can see that the values in the
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future are much much greater
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Tying this all to the DCF basically what
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we're saying is that you can't just
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calculate a company's future cash flows
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and then say oh that is the value
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of your company, you have to get those
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cash flows and discount it back
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to the present value or AKA today's
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value. Third there's the concept of
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future free cash flow and basically this
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refers to the fact that a company's
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value is based on the cash
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it's able to generate from today until
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the end of time
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Okay, so let's think about what this
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means if you think back to our bike
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analogy you remember that the bicycle's
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value was the ability of it to be able
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to generate cash until the end of time
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and that's true for any single company
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that you're trying to buy, whether it's a
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lemonade stand
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or a restaurant on the corner or nike or
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Tesla-
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the ability for these companies to
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generate cash that's really the value of
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the company
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Tying all of this together, let's go back
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to our definition just
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as a reminder. A DCF is a valuation
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methodology that measures the intrinsic
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value of a company
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based on the present value of its future
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free cash flows
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Okay so now that you understand the
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concepts behind the DCF, let's next talk
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about why it's important and when to use
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it
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First focusing on why the DCF is
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important
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really there's no other better way to
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find the intrinsic value of a company
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other than
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this method. But you don't have to just
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take my word for it
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every investor from Warren Buffett to
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Bill Ackman has stated in the past that
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a company's value
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is the sum of its future cash flows
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discounted back to present value
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Okay but with that said a DCF can't be
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used for
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every single type of company or at least
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it's not suitable for all companies
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and so let's talk a little bit about why
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that is. There are a lot of companies out
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there that just are cash flow negative
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and will be for the next you know five-
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who knows- maybe even 10 years and so for
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something like that you can't really
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create a model where you're projecting
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out future free cash flows because
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then basically you're gonna get to a
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negative number which means that someone
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has to
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pay you to buy the company which of
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course just doesn't make sense
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As a result, a super ideal candidate for
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a DCF would be a company that's been
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around for decades like let's say
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General Electric
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that doesn't really change its business
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model too often versus something like
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a tiny little startup. So doing a DCF
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analysis is kind of like a double-edged
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sword because you're
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able to cater your entire analysis to
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what you believe,
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but at the same time you better believe
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those assumptions are going to be
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correct because
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everything is really based on those
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assumptions and if they're right or
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wrong
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But just to be clear, you technically can
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create a DCF for
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any type of company no matter how
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unpredictable it is
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and for example back at my time at
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JP Morgan when I was covering healthcare
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companies
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I was creating DCFs for biotech
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companies that didn't even have drugs
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yet out on the market and wouldn't for
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the next few years and was projecting
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out cash flows for 20 to 30 years
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and basically we were just trying to see
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if we believed in certain assumptions,
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what would this biotech company be worth
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Let's next talk about how to do
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a DCF and the four key concepts. The
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first step is to project out future free
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cash flows usually out five to ten years,
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you then calculate the terminal value
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using either the exit multiple or
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perpetuity growth method,
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third you discount the free cash flow
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and terminal value back to present value
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using your whack,
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and lastly, you sum everything up to get
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your enterprise value which is the value
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of your company
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Now I'm going to show you this entire
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process with the Tesla DCF but there are
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four concepts that I mentioned here that
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I want to just dive a little bit more
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into the details and the formulas to
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really make sure that you understand
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these concepts because they're super
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fundamental to the entire DCF analysis
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The first one is free cash flow and this
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is your EBIT
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times 1 minus your tax rate plus
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depreciation and amortization
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minus capital expenditures minus your
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change in net working capital
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This is the formula for what's known as
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unlevered free cash flow and you can
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think of this
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as free cash flow available to all
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owners of a company,
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including both equity and debt holders
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You can also calculate what's known as
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your levered free cash flow by
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subtracting out interest expense
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and mandatory debt repayments but don't
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worry about that just focus on unlevered
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free cash flow for your DCF because
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that's really the best practice kind of
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for a DCF only focus on unlevered free
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cash flow
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Got that, unlevered free cash flow. And to
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explain the formula a bit more your EBIT
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stands for earnings before interest and
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taxes,
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and is basically your revenue minus cost
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of goods sold minus your operating
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expenses
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From here, you subtract out taxes and
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incorporate three common predictable
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cash flow items which are your D&A,
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CapEx and networking capital. Going into
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each of these different
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topics is going to kind of take a lot of
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time so basically what I'll do is define
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each of them
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and in the comments down below, I'll have
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a comment pinned
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where I define everything so make sure
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to check that out if you haven't really
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heard of what these concepts mean
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The second core concept is terminal
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value and this essentially is the value
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of your company
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from your last projected year until the
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end of time
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Now you can find this terminal value
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either through what's known as the exit
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multiple method or perpetuity growth
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method
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but I'm gonna only focus on the
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perpetuity growth method because
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at least at JPM that's the only thing I
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use and I personally think it's the best
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way to calculate your terminal value
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For the perpetuity growth method, the
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formula you use to calculate terminal
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value is your last projected cash flow
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figure
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times 1 plus your terminal growth rate
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all divided by
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your WACC minus your terminal growth
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rate. I know this formula might look
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super confusing but basically all it's
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doing is growing your company's cash
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flow until the end of time
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at a really really steady rate. The third
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concept is terminal growth rate and this
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just represents a steady state at which
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your company will grow
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until the end of time most of the time
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this rate is around two to three percent,
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which basically is the rate at which the
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us economy grows
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The theory behind this is basically if
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you think of the entire
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united states as one really large
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company basically obviously no company
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is going to grow
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larger than the united states, and so if
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you think the US economy can grow two
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to three percent,
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then any company in from now until the
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end of time they're probably not gonna
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grow any larger than two to three
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percent as
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they keep growing because as you get
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larger it's harder to grow faster
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The fourth concept is probably the most
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confusing and that is your weighted
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average cost of capital
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also known as your WACC now you
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probably remember me saying multiple
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times throughout the video that you need
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to discount back your future cash flows
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to present value
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and basically the rate that you use to
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discount back is your WACC
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The formula you need to know for WACC
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is your percentage of equity times cost
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of equity
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plus your percentage of debt times cost
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of debt times one minus the tax rate
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Going into this also would probably be a
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video on its own so basically I'll leave
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more about it in the comment below that
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I'll pin down
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Basically though what you need to know
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is that 10 is an average WACC while
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riskier companies go from around 11%
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to 15% while more stable companies go
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from around six percent to nine percent
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You can go lower or higher than this
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range but
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typically you'll see WACC in this range
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of about six percent to 15%
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Okay so now that you have all the
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concepts down let's go into the Tesla
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DCF
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First of all I want to really preface
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everything by saying that this is a
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really really really simple DCF just for
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illustrative purposes
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and I just want to show beginners kind
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of what it really
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looks like and so this is not in any way
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financial advice of me saying what Tesla
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stock is worth. In my next video, I'll be
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building on top of everything we
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discussed today and doing a more
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advanced DCF so
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if you haven't already and if you're
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interested click that
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subscribe button and while I have your
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attention please also
[756]
smash that like button because it would
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really really help support the channel
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Okay now let's go through the Tesla DCF
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with the four steps I previously laid
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out in the video
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First up is projecting out free cash
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flow and for Tesla I've projected it out
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for 10 years
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this really is the crux of the entire
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DCF because mostly
[773]
everything else is formulaic but this is
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where most of the really really
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important assumptions come into play
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The first thing you'll want to do is get
[781]
the past three to five years of
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historical figures basically so you can
[785]
see how the company has been performing
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As a quick pro tip, I like to go onto
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bamsec.com and download the tables
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and import them into my model and link
[794]
to them directly so that I know my
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numbers are 100% accurate
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Going back to our model, I'm not actually
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going to talk about how I got all these
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numbers and assumptions because they're
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probably all wrong- I just kind of
[806]
inputted random numbers and I just
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really wanted to show you what a DCF
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looks like
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So as you can see here I projected out
[812]
revenue for 10 years,
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then calculated EBIT as a percentage of
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revenue,
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subtracted out taxes, added back
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depreciation and amortization,
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subtracted capital expenditures, and
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subtracted change in networking capital
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all to get to our unlevered free cash
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flow, which you can see here
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Step two is to calculate the terminal
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value and so right here I used our
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perpetuity growth rate formula
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which as a reminder is our last year's
[838]
free cash flow
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times 1 plus the terminal growth rate
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all divided by our WACC
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minus the terminal growth rate and this
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gets us to
[846]
a terminal value of 876 billion 322
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million
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Step three is to discount the cash flow
[852]
and terminal value back to present value
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using our WACC, which we do by grabbing
[857]
our cash flow and dividing it by one
[859]
plus your whack to the power of each
[861]
respective year and for the terminal
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value discounting it from the furthest
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year out
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we've projected so year ten. Step four is
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to sum
[870]
up the present value of the cash flow
[872]
and terminal value to get to our
[873]
enterprise value of about
[875]
440 billion 651 million. And if you want
[878]
to get to our implied share price then
[880]
we would want to
[881]
add cash subtract that to get to our
[883]
equity value,
[884]
and divide by our shares to get to our
[886]
share price which as you can see here is
[889]
$463.93, which is much below
[892]
Tesla's last closing price of 625
[895]
dollars. So based on the current
[896]
assumptions I have in the DCF, it's
[898]
telling me that I probably don't want to
[900]
buy Tesla stock
[901]
but let me show you how changing a few
[903]
assumptions can drastically change
[905]
everything in the model. Initially, we got
[907]
to a share price of about 464 dollars
[910]
but if we want to change our whack to 10%
[913]
and 2030 growth rate to 12%
[916]
you can see that our share price jumps
[917]
to $732.83,
[920]
which implies that we may want to buy
[922]
Tesla. So as you can see the DCF
[925]
is an incredibly flexible tool that you
[927]
can use
[928]
but of course it also can be a little
[930]
bit unreliable or iffy because you just
[932]
really have to make sure that you
[934]
think your assumptions are correct and
[936]
if you think about trying to project out
[938]
anything from one to five years no
[939]
matter what it is like who's gonna win
[941]
a certain baseball game or a basketball
[943]
game in the playoffs or something like
[945]
that
[946]
it's so hard to predict who even like
[948]
who's gonna enter the playoffs or
[949]
something like that, right?
[950]
And so if you think about entire
[952]
companies how massive they are, how
[954]
quickly industries change,
[955]
all the assumptions you put into a DCF
[958]
are almost 100 gonna be wrong
[960]
and so basically the DCF is just one
[962]
tool that you use to kind of
[964]
use as a gut check to see okay is this
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company undervalued
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or overvalued based on what I put here
[970]
in the
[971]
model, and is the price too crazy right
[974]
now do I have to believe in
[975]
insane revenue growth numbers or really
[977]
really high EBIT, EBITDA margins
[980]
in order for me to think that the
[981]
company stock price you know deserves to
[983]
be at a certain level- that's really what
[985]
the DCF is for
[986]
and you want to incorporate it with
[988]
other kind of like qualitative
[989]
information
[990]
like what the management team is
[993]
going to do over the next few years or
[994]
what they say they're going to do, who
[995]
they are,
[996]
how quickly the industry's growing, what
[999]
additional products you might see in the
[1000]
pipeline you know that's all the really
[1002]
the stuff you want to be looking at as
[1004]
well as your DCF
[1005]
Alright guys props to you if you made
[1007]
it throughout this entire video because
[1009]
you're on your way to becoming a better
[1011]
and smarter investor- I've been getting a
[1013]
lot of requests of these kind of how-to
[1015]
videos and so
[1016]
please leave me a comment down below if
[1018]
you found this helpful and
[1019]
interesting and also please help out the
[1021]
channel by clicking the like button and
[1023]
subscribing and turning on post
[1025]
notifications if you'd like
[1027]
one reason why why you might want to
[1029]
turn on those notifications is because
[1031]
as I said in previous videos
[1032]
I award ten dollars to the first person
[1034]
who comments and also
[1035]
random commenter so here are our winners
[1038]
for today
[1039]
If that is you just dm me on instagram
[1042]
to collect your winnings
[1043]
and the last thing I want to mention is
[1044]
that you can get some free money by
[1046]
looking in the description below and
[1048]
seeing the different exchanges that are
[1050]
offering some rewards right now so you
[1052]
can for instance on Coinbase,
[1054]
deposit some money and get 10 free and
[1056]
bitcoin you can get free stocks from
[1058]
signing up on weeble and moomoo
[1060]
so check those out if you want some free
[1062]
money by signing up for those exchanges
[1064]
Alright that concludes the video thank
[1065]
you so much as always for
[1067]
watching, please feel free to tune in for
[1069]
the next video coming out in a few days,
[1071]
thanks as always peace out
[1081]
[Music]
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