# BuffettJunior1 (97.79)

## BuffettJunior1's CAPS Blog

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May 20, 2011 – Comments (36)

Many people have been asking me to teach them how to perform a discounted cash flow analysis on a company. Luckily, I won’t be forced to type it out. I found a good example of it on Morningstar and have copied here. Remember, there are 2 main ways of doing DCF. Using "free cash flow to equity" and "cash flow to the firm."

The following example will show you how to do DCF using free cash flow to equity. This is the simplest and best way to do it, and it’s the way Warren Buffett does it as well.

To get an introduction to DCF go to the link bellow:

http://news.morningstar.com/classroom2/course.asp?docId=145101&page=1&CN=COM

Putting DCF into Action

Now that we have covered the workings of discounted cash-flow (DCF) models in general and a bit about how we treat them at Morningstar, we'll dig a little deeper into how to determine fair values for stocks. In this lesson, we'll walk you through a step-by-step sample DCF model that uses the "free cash flow to equity" method. Here are the main steps to generating a per share fair value estimate with this method:

Step 1. Project free cash flow for the forecast period.

Step 2. Determine a discount rate.

Step 3. Discount the projected free cash flows to the present, and sum.

Step 4. Calculate the perpetuity value and discount it to the present.

Step 5. Add the values from Steps 3 and 4, and divide the sum by shares outstanding.

The first step in projecting future cash flow is to understand the past. This means looking at historical data from the company's income statements, balance sheets, and cash-flow statements for at least the past four or five years.

Once you've examined the historical data and perhaps entered it into a spreadsheet program, it's time to project the company's free cash flow in detail for the next couple of years. These projections are the meat of any DCF model. They will rely on your knowledge of the company and its competitive position, and how you expect things will change in the future. If you think profit margins will expand, or sales growth will slow dramatically, or the company needs to increase its capital expenditure to maintain its facilities, your projections should reflect those predictions.

Next, we need to estimate the company's "perpetuity year." This is the year at which we feel we can no longer adequately project future free cash flow. We also need to make a projection concerning what the company's free cash flow will be in that year.

To begin, let's suppose that the fictitious firm Charlie's Bicycles generated \$500 million in free cash flow last year. Let's also assume that Charlie's current lineup of bikes are very hot sellers, and the company is expected to grow free cash flow 15% per year over the next five years. After five years, we assume competitors will have started copying Charlie's designs, eating into Charlie's growth. So after five years, free cash flow growth will slow down to 5% a year. Our free cash flow projection would look like this:

Last Year: \$500.00
Year 1: 575.00
Year 2: 661.25
Year 3: 760.44
Year 4: 874.50
Year 5: 1005.68
Year 6: 1055.96
Year 7: 1108.76
Year 8: 1164.20
Year 9: 1222.41
Year 10: 1283.53

Because we're using the "free cash flow to equity" method of DCF, we can ignore Charlie's cost of debt and WACC in coming up with a discount rate. Instead, we'll focus on coming up with an assumed cost of equity, using the principles highlighted in the previous lesson.

Charlie's has been in business for more than 60 years, and it has not had an unprofitable year in decades. Its brand is well-known and respected, and this translates into very respectable returns on its invested capital. Given this and the relatively stable outlook for Charlie's profits, settling for a 9% cost of equity (lower than average) seems appropriate given the modest risks Charlie's faces.

The next step is to discount each of the individual year's cash flows to express them in terms of today's dollars. Remember we are using the following formula, and the "discount factor" just represents the denominator in the equation. We can then multiply each year's cash flow by the discount factor to get the present value of each cash flow.

Present Value of Cash Flow in Year N =
CF at Year N / (1 + R)^N

CF = Cash Flow
R = Required Return (Discount Rate), in this case 9%
N = Number of Years in the Future

Last Year: \$500.00
Year 1: 575.00 x (1 / 1.09^1) = 528
Year 2: 661.25 x (1 / 1.09^2) = 557
Year 3: 760.44 x (1 / 1.09^3) = 587
Year 4: 874.50 x (1 / 1.09^4) = 620
Year 5: 1005.68 x (1 / 1.09^5) = 654
Year 6: 1055.96 x (1 / 1.09^6) = 630
Year 7: 1108.76 x (1 / 1.09^7) = 607
Year 8: 1164.20 x (1 / 1.09^8) = 584
Year 9: 1222.41 x (1 / 1.09^9) = 563
Year 10: 1283.53 x (1 / 1.09^10) = 542

We then add up all the discounted cash flows from Years 1 through 10, and come up with a value of \$5,870 million (\$5.87 billion).

In this step, we use another formula from the last lesson:

Perpetuity Value =
( CFn x (1+ g) ) / (R - g)

CFn = Cash Flow in the Last Individual Year Estimated, in this case Year 10 cash flow
g = Long-Term Growth Rate
R = Discount Rate, or Cost of Capital, in this case cost of equity

Morningstar analysts generally use 3% as the perpetuity growth rate, which is close to the historical average growth rate of the U.S. economy. We'll assume that after 10 years, Charlie's Bicycles will also grow at this 3% rate. Plugging the numbers into the formula:

( \$1,284 x (1 + .03) ) / (.09 - .03) = \$22,042 million

Notice that for the cash flow figure we used the undiscounted Year 10 cash flow, not the discounted \$542 million. But because we used the undiscounted amount, we still need to express the perpetuity value in present-value terms using this trusty formula:

Present Value of Cash Flow in Year N =
CF at Year N / (1 + R)^N

Present Value of Perpetuity Value =
\$22,042 million / (1 + .09)^10 = \$9,311 million

Now that we have the value of all the cash flows from Year 1 through 10 as well as those from Year 11 on, we add up these two values:

Discounted Free Cash Flow, Years 1-10: \$5,870 million
+ Discounted Free Cash Flow, Years 11 on: \$9,311 million

which equals \$15,181 million.

So there we have it! We have estimated Charlie's Bicycles to be worth \$15.2 billion. The final, simple step is to divide this \$15.2 billion value by the number of shares Charlie's Bicycles has outstanding. If Charlie's has 100 million shares outstanding, then our estimate of Charlie's intrinsic value is \$152 per share.

If Charlie's stock is trading at \$100 per share, you should start to get interested in buying the shares. We can forget about what Charlie's P/E ratio is relative to its peers as well as what Wall Street analysts have recently said about the stock. The bottom line is the stock is trading below its estimated intrinsic value. If you have confidence in your free cash flow projections, you can have an equal amount of confidence in buying the stock.

As you may tell, this is merely a simple example of how to use a DCF model, but it's still not exactly "simple." Not many people put this much work into their investments. But if you're willing to go through the effort of creating a DCF model for a company you are interested in, you will be much more informed and confident than the vast majority of other investors.

There are numerous small twists that the other type of DCF model (cash flow to the firm) uses, but the output should be approximately the same no matter which DCF method you use for a given firm. Also keep in mind that a model does not need to be super-complex to get you most of the way there and help you clarify your thinking. Remember, using a similar DCF model can take you a long way in finding superior companies trading at a discount to their intrinsic value--the key to a profitable long-term investing strategy.

I know it looks like a lot of hard work, but trust me it’s worth it. Discounting a company's future cash flows is the only way to find its intrinsic value. If you really focus on DCF, you will never again worry about EPS estimates, P/E ratios or any of that nonsense. If you guys have any questions don’t hesitate to ask. Just post your questions in a comment box bellow.

#1) On May 20, 2011 at 12:58 PM, mtf00l (43.33) wrote:

Thank you for posting this information and the link to lean more.  Well done.

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#2) On May 20, 2011 at 1:16 PM, L0RDZ (90.16) wrote:

How do you figure the discount rate  and how do you account for intangibles  like  bad management ?  good management ?

Governmental  regulations and  tinkering ??   too big to fail ? bail ?

And who's numbers  do you use  and where do you get them ?

LORDZ  may be old but can learn new tricks :)

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#3) On May 20, 2011 at 1:17 PM, L0RDZ (90.16) wrote:

What if the cash flow is mostly  from borrowing ???

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#4) On May 20, 2011 at 1:32 PM, russiangambit (28.88) wrote:

> How do you figure the discount rate

Yes, that is my favorite part because if discount rate is 0-2% like it is right now  you get very didfferent result is you use 5-7%. So, how do you projct the cost of money and the fixed costs of raw materials with any accuracy?

DCF is useless beoynd 2-3 years.

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#5) On May 20, 2011 at 1:41 PM, BuffettJunior1 (97.79) wrote:

Finding the discount rate is one of the most debated topics in finance. It shouldn't be. Think of the discount rate as the minimum return on your investment.

What I do is I look at the "risk free rate," which is the yield on the 30 year t-bond. The current yield is about 4.3%. So you could earn a 4.3% return on your investment without taking any risk. However, most of us would want a slightly higher return than the risk free rate. What I do is I take the risk free rate, 4.3% right now, and I add a 3% risk premium to that. So your discount rate would be 7.3%. This is a very simple and effective way of determining your discount rate.

There is also another way of doing it. Joe Ponzio, the author of "FWallstreet," suggests using a 9% discount rate or the risk free rate, whichever is higher.

I don’t want to confuse you with all this. The simplest thing you can do is take the risk free rate and add 3% to that. The goal is to be consistent. Use the same discount rate for every company that you do DCF on. So if your discount rate is 9%, use that for all companies. If its 5% then use that. It really doesn’t make a difference what discount rate you use as long as it’s consistent and reasonable.

The biggest mistake you can make is changing the discount rate for each company in order to take into account the risk. If a company is more risky, don’t increase the discount rate. Increase your margin of safety. The margin of safety is pretty much the difference between a stocks intrinsic value and its current value. For example, let’s say Apples intrinsic value is 500 per share, but it’s currently trading for 300 per share. The margin of safety would be 40% = 1 - (300/500). So if a stock is more risky then you want to increase your margin of safety, keep the discount rate constant.

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#6) On May 20, 2011 at 2:23 PM, L0RDZ (90.16) wrote:

What if the cash flow suddenly turns negative  ?

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#7) On May 20, 2011 at 2:24 PM, ikkyu2 (97.97) wrote:

Many people have been asking me to teach them how to perform a discounted cash flow analysis on a company

Is this before or after you post a comment on their blog berating them for not performing a DCF?  :)

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#8) On May 20, 2011 at 2:28 PM, ikkyu2 (97.97) wrote:

By the way, the risk-free rate is usually estimated as the rate on the 3-month T-bill, not the rate on the long bond.  The reason is that when you are thinking about committing money to a stock you're doing a DCFA on, you are not thinking of a 30 year time horizon.

Well, maybe you are; I personally find that trying to know what kind of cash flow a company will generate in 4Q 2040 is a little cloudy.

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#9) On May 20, 2011 at 2:32 PM, ikkyu2 (97.97) wrote:

Just to be clear - because I get the feeling you don't really understand the objections to your method - this method is only as good as its assumptions.  You make assumptions about future cash flows and you make assumptions about the appropriate discount rate.  If those assumptions are garbage, then garbage-in, garbage-out applies; the results of the DCFA that use those assumptions will be garbage too.

Trailing EPS and P/E numbers, on the other hand, represent facts, assuming they're accurately reported.  You do not need to assume anything when you are told Apple took in 20 billion dollars of revenue in a prior quarter; 20 billion dollars is 20 billion dollars.

Knowing the difference between facts and assumptions is important if you want to get rich.

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#10) On May 20, 2011 at 2:37 PM, BuffettJunior1 (97.79) wrote:

LORDZ,

It is possible that a company's cash flow could turn negative. That why you should only perform DCF on companies that have predictable cash flow. In fact, you should only BUY stocks of companies that have predictable cash flow. A good example of what I'm talking about is Coca-Cola, ticker is KO. When Warren Buffett bought it decades ago, he was almost positive that the company could grow its cash flow for a very long time. Now, not every year is going be perfect. However, over a 5, 10 or 20 year period, the cash flow should trend up. By using conservative growth rates, you will take into account some bad years where the company is not going to be as profitable.

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#11) On May 20, 2011 at 2:43 PM, L0RDZ (90.16) wrote:

What if Apple is really some big lie ???  suppose they are cooking the books ?  and not to pick on Apple,  lets say  its company  XYZ,  I only  used Apple because  someone  mentioned apple, I could have just the same  said  Coke ?

Companies  sometimes have to restate  numbers ?

So who is more correct ?  Buffet JR  or the other helper ? IKKyu2 ?

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#12) On May 20, 2011 at 2:50 PM, BuffettJunior1 (97.79) wrote:

Ikkkyu,

Actually you’re wrong about the risk free rate. Buffett uses the 30 year t-bond, however, I know people who use the 10 year t-note. I prefer to stick to the 30 year t-bond; the yield is higher which gives you a more conservative risk free rate.

To answer your other question. Using DCF is not easy and can’t be done on every company. You can and should only do a discounted cash flow analysis on companies that you truly understand. Companies with good return on capital, good cash flow, etc...If done right, DCF is the best way to find a stocks intrinsic value. Buffett has done it for decades and it made him the greatest investor who ever lived.

Your right about the "garbage in garbage out." But, if you truly understand the business, and use conservative growth rates, discount rates, etc... Then you will do very well.

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#13) On May 20, 2011 at 2:53 PM, mtf00l (43.33) wrote:

Test

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#14) On May 20, 2011 at 2:57 PM, mtf00l (43.33) wrote:

Interesting development, I've tried to post the same comment four times and four times it has gone to cyberspace except for my "Test" post.

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#15) On May 20, 2011 at 2:59 PM, mtf00l (43.33) wrote:

Fifth try,...

I'll try the rest of the comment in a seperate post.

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#16) On May 20, 2011 at 3:02 PM, mtf00l (43.33) wrote:

Currently unable to post links.  Wikipedia, search for Discounted_cash_flow

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#17) On May 20, 2011 at 3:06 PM, BuffettJunior1 (97.79) wrote:

LORDZ,

In order to know whether or not a company is, as you say, "cooking the books," you have to be a good accountant. You have to know how financial statements are made and how companies can manipulate them.

For example, I know that a very popular stock, called Green Mountain Coffee Roasters Inc., the ticker is GMCR, is manipulating its financials. How do I know that? Just take a look at the difference between its cash flow and its reported earnings. The company is reporting record EPS quarter after quarter, but is actually earning less and less cash. In 2010 the company reported 80 million in net income, but actually lost 10.5 million. You would know this by looking that the cash.

This is just one example of one of the things a company can do. There are literally hundreds of ways companies can manipulate their financials. You just have to be a good accountant to catch these little tricks.

If you do see that a company is being shady, I suggest you stay far away from it. Doing DCF on companies like this is not going save you from losing money.

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#18) On May 20, 2011 at 3:08 PM, TheDumbMoney (78.53) wrote:

1) Buffet does use the 30-year T-Bond.

2) When rates are low, as now, I always add a much larger amount to my discount rate, because interest rates will fluctuate over 30 years and will likely be much higher at some point.  While I recognize one is investing now, the company's cost borrowing may therefore increase (this is more relevant if there is any debt at all) during that time.  Plus this makes things more conservative.

3)  Note, one can very easily input all of these calculations into an Excel spreadsheet so that all you have to do is plug in a few numbers (discount rate, starting cash flow, share count, etc.)  I did it in an hour or two one weekend.  Now it's just cut-and-paste.

4) Also, lots of people criticize the utility of estimating that far out.  I get that.  On the other hand, that's the whole point of using the margin of safety principle.  You get a range of reasonable values for the stock, showing a variety of potential outcomes, and then you buy when the stock is below even the more pessimistic outcome's intrinsic value calculation.  For example, Microsoft may suck, but the last time I ran a DCF on it a few months ago, the market was pricing it basically to have no growth at all.

5)  The above model is flawed in that it does not account for net cash, at least if the ultimate focus is on intrinsic value.  You also can build in the "backing out" of net cash (cash and cash equiv, minus debt).  Note that if it's a company like Microsoft that has tons of cash abroad (that it hasn't paid taxes on) you don't necessarily want to give it full credit for all of that cash.

6)  Also note, one further limit on DCF is that it is not ACTUALLY cash going into your pocket.  It is cash going to the company.  A company may be a terrible deployer of free cash flow.  That is why a DCF should never be employed in a vacuum, it should always be paired with an analysis of things like return on equity, and whether the company generates an extra dollar of share value per each dollar of retained earnings.  Sometimes I forget to do this one, but it's important.

7)  You don't then need to add value for "quality management."  That is reflected in things like return on equity; adding more value because you think management is good, after nothing a high return on equity, is in my view essentially double-counting (and my view is basically just parroting some investment guru I read, and who I agreed with).

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#19) On May 20, 2011 at 3:09 PM, TheDumbMoney (78.53) wrote:

Also, the reason some people change their discount rates is because they are using it as a proxy for WACC, which differs by company and also by industry.

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#20) On May 20, 2011 at 3:34 PM, BuffettJunior1 (97.79) wrote:

dumberthanafool,

Your right about the discount rate. That why I always add 3% to the risk free rate to give me a more conservative discount rate. As I mentioned above, it’s all about using a reasonable discount rate and sticking with it. Changing your discount rate from company to company will actually hurt you more than help you. Consistency is key! Use a higher margin of safety for higher risk companies, not a higher discount rate.

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#21) On May 20, 2011 at 4:21 PM, tekennedy (92.71) wrote:

@buffetjr- I'd say using different discount rates for different companies has its merits if used properly. When you consider a growth company which will experience high yet uncertain growth, it is more difficult to estimate year 10 than year 5. A higher discount rate will factor that in to a greater degree.

Also you can discount negative cash flows, it just lowers the NPV. A negative cash flow doesn't even necessarily mean its a bad company; they could be investing in a new warehouse or adding stores, etc. Its far tougher to perform a DCF on companies with variable earnings but it can be worthwhile.

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#22) On May 20, 2011 at 4:40 PM, ElCid16 (93.82) wrote:

By the way, the risk-free rate is usually estimated as the rate on the 3-month T-bill, not the rate on the long bond.

It depends on the time horizon of your DCF model.  If you are using a DCF model to find stocks that you want to invest in for a year or two, use a 1 year treasury bond.  If you want to find stocks that you plan on investing for 30 year, use a 30 year rate.  You are comparing your potential investment against a "risk-free" option of a similar time frame.  Buffett invests for the long haul - that's why he uses the 30 year rate.

I personally agree with russiangambit's statement above...the DCF model is too hard to use for the average investor to predict beyond a couple of years.  For a company like JNJ, a 1 percent change in growth, risk free rate, WACC, etc. leads to a difference in your valuation of billions of dollars.  If you think you can pick JNJ's wacc better than a handful of GS I-bankers or hedge fund managers, you're kidding yourself.

Nonetheless, its a very cool tool to develop, and interesting to use, if nothing else.  Give it a shot as a learning experience.  If you've never built one before, I'd recommend starting with a discounted dividend model...it can be done in an afternoon rather than a weekend.

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#23) On May 20, 2011 at 5:08 PM, L0RDZ (90.16) wrote:

So out of giggles... lets do a sample  DCF  on one of my  fav companies I like to  drink :)

PEP   :   PEPSI........  anyone  feel free to  perform  such an analysis  it should be interesting especially if we  have  more than one person to compare  at least the differences in  their  said   analysis ???

Buff please  do  a quick  DCF  on PEP  perhaps  Ikkyu2  could do one as well and we could compare it to how the stock is currently performing ???

It would be interesting to see the comparison between the 2 especially since  there are  differences of opinion on whether to use  the 3 month  or the 30 year rates :)

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#24) On May 20, 2011 at 5:09 PM, L0RDZ (90.16) wrote:

Just as a bribe I'll rec this :)  lol.....   for your consideration ;-)  I would like to see your skills.

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#25) On May 20, 2011 at 5:09 PM, L0RDZ (90.16) wrote:

Ya know have  9 recs....

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#26) On May 20, 2011 at 5:14 PM, L0RDZ (90.16) wrote:

Lets  use a  9-11%  discount  rate.

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#27) On May 20, 2011 at 5:39 PM, BuffettJunior1 (97.79) wrote:

LORDZ,

You need to fully understand the company before you can perform a DCF analysis on it. How has it performed over the past 10, 20 or more years? What does management plan on doing in order to grow the business? There are countless questions that you have to answer before you can even begin to do a DCF analysis on a company. You pretty much have to understand and learn everything about the company that you are planning to invest in.

Here is what I did for one of my favorite small caps right now. Remember, I did this after I reviewed the financials, annual report, etc..

The company is called PetMed Express, Inc., the ticker is PETS. I used a very conservative growth rate, the company will almost certainly grow faster than what I used in my model.

10% FCF growth for years 1-5

5% FCF growth for year’s 6-10

Perpetuity growth rate is 3%

I used a discount rate of 7.5%. I came up with that by taking the risk free rate (yield on the 30 year t-bond) and adding a 3% risk premium to that.

The intrinsic value for this stock is just over 39 per share. If the company can exceed my growth projection, which it probably can, then the stock can be worth far more. Include with that a healthy dividend that you can reinvest and buy more shares, and this could be a great stock for the long term.

The company is actually growing in value while its stock is getting cheaper; this is the perfect condition for value/growth investors.

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#28) On May 20, 2011 at 5:47 PM, L0RDZ (90.16) wrote:

Seems to me if you fully understand ??  a  dcf ?? is than  almost worthless ?  because  then  your either tinkering with some numbers to basically justify  your  original opinion  and than what if no one else has the same  thoughts  or  analysis.

One could crunch it all, but if mister market says your a loser....  more than likely  the market price is  truth....   and the truth can crush..   ??

I believe Pepsi  is on a big  acquisition spree  helping it to grow, make more money  and  increase its dividend.

When I first bought pep  its dividend  was only  37 cents  now its gonna be  51.5  :)

a  nice  near  40%  increase in nearly  2 years....  now people  what other big company can say they did the same to their dividend ???

safely ???

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#29) On May 20, 2011 at 6:01 PM, Starfirenv (< 20) wrote:

http://www.gurufocus.com/fair_value_dcf.php

A DCF calculator- just fill in the blanks.  Excellent site also. It's worth a few mins to explore if you havn't already.  Best

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#30) On May 20, 2011 at 6:04 PM, BuffettJunior1 (97.79) wrote:

LORDZ,

The point of doing DCF analysis is to find the stocks intrinsic value. Once you know what the stock is worth, your next goal should be to buy it at a significant discount to its intrinsic value. I like to buy stocks trading at a 50% discount or greater. That's how you make the real money in investing. It’s a lot of hard work, but it’s worth it.

Just knowing that a stock is going to be worth more 5 or 10 years from now is not enough. You have to know what it’s going to be worth so that you can buy it at the right price and make a big profit.

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#31) On May 20, 2011 at 6:07 PM, BuffettJunior1 (97.79) wrote:

Starfirenv,

It's a good website, but their DCF calculator is not very good. It's actually very different from what Buffett uses.

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#32) On May 20, 2011 at 8:58 PM, Valyooo (35.29) wrote:

So you say the only way to get around the fact that a lot of assumptions are used is to know the business very well.   If you know the business well, why do you need to use a DCF?  All you have to know is "do I think this company will outperform its peers in the given time frame"?  If yes, check a simple chart and your macroeconomic view...if its overbought  or the economy will collapse hold on.  Otherwise, buy it, buy more on dips.

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#33) On May 20, 2011 at 9:12 PM, BuffettJunior1 (97.79) wrote:

Valyooo,

It's easy to say a company will outperform. The trick is finding it's intrinsic value. If you know the intrinsic value then you know what you should pay to make a significant profit.

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#34) On May 20, 2011 at 10:14 PM, Valyooo (35.29) wrote:

I just think its easier to buy when there is fear or a stupid sell off or the chart says cheap or a one time mistake causes a sell off.  Its pretty easy to eyeball when a good company is cheap IMO.  DCA helps too...I jsut think DCF has too many assumptions that aren't even worth it.

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#35) On May 21, 2011 at 12:30 PM, TheDumbMoney (78.53) wrote:

Valyooo, did you get a job after graduation yet, hope so, good luck with that, I think you're a good active trader-type.

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#36) On May 26, 2011 at 2:28 AM, ikkyu2 (97.97) wrote:

For what it's worth, BuffettJunior1, I thought you did a nice job explaining and defending the FCF analysis method and pointing out its particular utility in finding a stock that's on sale for a discount.  I used something similar to get into AAPL 2, 5, and 30 years ago, and I actually sat down and did a DCF analysis by the book on Intel 3 months ago, and found that by nearly any pessimistic assumption it was at least 30% undervalued, maybe more if you assume it has some earnings growth coming in the next 5 years.

I have also been taking a whack - in my head, not on a spreadsheet - at AMZN, doing a free cashflow analysis once or twice a year since 1994.  The stock has *never* been undervalued by my calculations in that entire time, usually 50%+ overvalued at least, sometimes far more.  Hence, I own none - and have missed out on some colossal price appreciation.  In other words, the DCF will not get you a seat on every boat; many perfectly good boats set sail without the DCF investor on board.

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