Fundamental: Discounted Cash Flow (Part 4)

The concept of Net Present Value (NPV)

This article is a part of our series on how to choose your stocks for investment using fundamental analysis. Net Present Value (NPV) is a component under the third stage of the analysis, which is known as Discounted Cash Flow (DCF). As a quick recap, there are three stages to fundamental analysis (generally speaking).

The first step is to look at the business overview to get a first glance at how the business is doing generally. If they pass the test, move to the next step and apply financial ratio analysis on these stocks to see if it supports your initial findings. If this step is passed, move on to the last step, which is to look at Discounted Cash Flow (DCF) to see if the price that you’ll buy it at is worth it or not.

We are now at the last step. However, mind you there are a few core concepts that we’ll need to master before we can actually jump into the DCF evaluation. In this article, we will learn the third concept which is the terminal value.

What have we learned about DCF so far?

Before this, we’ve learned about:

Future & Present Value tells you how much the money that you can get from your investment later might be worth now (or how much the money you have now could be worth later); while Free Cash Flow tells you how much a company makes from its operation minus its capital expenditure. Terminal Value tells you the estimated future value of an investment beyond the forecasted period, used to determine its intrinsic worth.

The NPV is simply a step further from getting the Free Cash Flow and Terminal Value where you now try to see how much the money is worth now. How so? When you invest in a stock, you let go of the chance to invest in something safer to chase higher returns. Long story short, the money that you can get in the future might not be worth much if you factor in the easier opportunity that you let go of.

So, in order to be proud of yourself when you invest. You’ll need to make sure that the Present Value of the money you make later on is better than if you had invested in safer assets.

These concepts, if paired with the NPV that we are going to discuss now, can be used to estimate the fair value of a share later on. Simply, it can tell you if the price of the stock that you want to buy is a reasonable price or not.

How to get the NPV?

You will need to add the sum of the present value for the stock’s Free Cash Flow and the Present Value of its Terminal Value.

NPV = PV of Free Cash Flow + PV of Terminal Value

Here’s the formula for Present Value, it is the same formula as the ones we used in our previous article:

Present Value = Amount / (1 + discount rate) ^ Number of years

*The discount rate that we came up with is 4.21%. Why 4.21%? In short, that is the risk-free rate of investment. If you want to know more, head to this article and go to the “Present Value” paragraph.

For this, we will use Apple’s 2022 Annual Report. The value that we obtained is as mentioned below, and if you want to see how we came up with it feel free to read the article below:

The second component: Free Cash Flow

“Terminal Growth Rate?”

If you look into the first method, which is the one that we will use, you can see the term “terminal growth rate” in its formula. So, what does it mean?

Terminal Growth Rate, in the context of stock investment, refers to the rate at which a company’s cash flows are expected to grow indefinitely into the future after a specified projection period. Simply, it is a rate at which the company will grow forever (the “forever” here is just theoretical, nothing lasts forever. You’d understand this better than I do).

After reaching a certain ‘age’ the company’s growth would usually slow down a bit, in which previously we put a company’s growth rate for the first 5 years of the projection to be at 12% and 8% for year 6th to year 10th (we made the 8% up, but the number is usually not far from that).

After the 10th year, when the company (presumedly) goes into old age, its growth would usually decline further. We will put it at 4% for the sake of this example. (There’s no particular reason for this, but you can play it by the ears and experience. If the company seems to be growing at a bigger pace, you can move the projection to be a bit higher, and vice versa).

Let’s see how the calculation works in the wild, shall we?

Step 1: Calculate the present value for all of the future cash flow

Right now, we already have the value for the future cash flow per below:

We use MS Excel for the calculation, so here’s how roughly it would look like:

Now we’ve got the Sum of Apple’s Free Cash Flow (FCF) Present Value, which is $647.97 billion.

Per the above, the calculation is as follows (we only give the example for the calculation of the first year’s present value):

Present Value = Amount / (1 + discount rate) ^ Number of years

Present Value = 80.275 / (1 + 4.21%) ^ 1

Note that the “number of years” depends on which year’s value you’re calculating. If it’s the second year, then it will be …^ 2. And so on.

Here’s what the calculation in Excel looks like.

Step 2: Calculate the Present Value of the Terminal Value

We already have the Terminal Value from our previous article. If you want to see how it’s counted, check out the article below! The Terminal Value that we have is $40,193.52 billion ($40.19 trillion).

Fundamental: Discounted Cash Flow (Part 3)

Let’s churn that into our formula:

Present Value = Amount / (1 + discount rate) ^ Number of years

Oh, and we’re using the 10th year for the Terminal Value’s year.

Present Value = 40,193.52 / (1 + 4.25%) ^ 10

Present Value = 26,509.1257515

Hence, the Present Value of the Terminal Value is $26,509.13 billion.

Step 3: Sum up the Present Value of Free Cash Flow and Terminal Value

Back to our formula for NPV:

NPV = PV of Free Cash Flow + PV of Terminal Value

We’ve got both values already.

PV of Free Cash Flow: $647.97 billion

PV of Terminal Value: $26,509.13 billion

NPV = PV of Free Cash Flow + PV of Terminal Value

NPV = 647.97 + 26,509.13

NPV = $27,157.1 billion

Now we’ve got Apple’s NPV based on its price projection from 2018 to 2027.

Bottom line

NPV tells you how much money you can make later on from an investment that might be worth in now’s context.
NPV = PV of Free Cash Flow + PV of Terminal Value
Once you get the NPV, you can move on to the next step which is to see how the share price should be based on its cash flow data.
Here’s a summary: To do a fundamental analysis, you’ll have to look at the general business overview, financial ratio analysis, and DCF analysis.
Under the DCF analysis, there are a few things that you’ll have to know of such as Future & Present Value, Free Cash Flow, Terminal Value and Net Present Value — all of which will be churned to see the fair share price of a stock.

The key takeaways/market update is a series by AxeHedge, which serves as an initiative to bring compact and informative In/Visible Talks recaps/takeaways on leading brands and investment events happening around the globe.

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