Fundamental: Discounted Cash Flow (Part 5)

How to see if the share price is reasonable

This article is a part of our series on how to choose your stocks for investment using fundamental analysis. We are at the last part of Discounted Cash Flow (DCF) where we will now look into how to use what we have learned so far and calculate the fair share price of a stock — or simply, how to know if the share price is a good buy or not.

Just a quick recap on the overall steps needed to see if a stock is worthy of investment, 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.

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 can be used to estimate the fair value of a share to see if the price of the stock that you want to buy is a reasonable price or not, given the company’s financial performance.

How to get the fair share value of a stock?

To do this, you will need to do a few ‘sub-steps’.

1. Look for the NPV

When it comes to NPV, we will stick with the numbers that we have previously calculated. If you want to see how. Get a quick look here:

Net Present Value (NPV)

Long story short, the NPV that we got for Apple is $$2,591,276,440,780

2. Look for the Net Debt

Just to refresh our memory, the formula to calculate Net Debt is as follows:

Net Debt = Current Year Total Debt — Cash & Cash Balance

So, what we need to look for are these two things:

Current Year Total Debt
Cash & Cash Balance

To look for the current year total debt, you can look at Apple’s balance sheet, the current debt that it has is $11,128,000,000.

As for the cash & cash balance, we can find it in Apple’s Consolidated Statement of Cash Flows.

So, the Cash & Cash Balance is roughly $24,977,000,000.

Now, back to our formula:

Net Debt = Current Year Total Debt — Cash & Cash Balance

Net Debt = 11,128,000,000–24,977,000,000

Net Debt = -13,849,000,000

Step 2: Calculate the Total Present Value of Free Cash flow

Now that we have all the numbers needed, let’s look at the formula again, and fill in the blanks.

Total Present Value of Free Cash flow = NPV — Net Debt

Total Present Value of Free Cash flow = 2,591,276,440,780 — (-13,849,000,000)

Total Present Value of Free Cash flow = $2,605,125,400,000

Step 3: Calculate the Share Price

Here’s the formula:

Share Price = Total Present Value of Free Cash flow / Total Number of shares

As of September 2022, Apple’s outstanding shares are 15,943,000,000 units.

So,

Share Price = 2,605,125,400,000 / 15,943,000,000

Share Price = 163

Share Price = $163

Well, that’s not too hard, isn’t it?

Important: Give it a little bit of 'breathing room'.

Despite getting $163 from the calculations above, we have to entertain a certain level of assumptions in order to achieve that. So, it would be prudent if you take the end result with a grain of salt and add something around 10% above the result for us to consider if the price is reasonable.

So, if the price is $163, the upper band would be $179.30, while the lower band of an acceptable price would be $146.70.

Hence, based on Apple’s 2022 financials, the reasonable price for its share is around $146.70 to $179.30.

If you look at Apple’s price, it did go around that price before Warren Buffet boosted the price with his bullish statement on Apple.

Oh, and if you want a sample of our Excel sheet for DCF, you can download it here! (But do note that it’s for educational purposes only).

Bottom line

The whole Discounted Cash Flow series is directed here, where you will finally be able to estimate how much a stock is actually worth based on its financial performance.
The formula to look if a stock is undervalued or overvalued is: Share Price = Total Present Value of Free Cash flow / Total Number of shares
To get to this point, you may need to learn a few core concepts first, i.e., Future & Present Value, Free Cash Flow, Terminal Value, and Net Present Value (NPV)
Be sure to have a bit of ‘leeway’ with the price range, since the calculations played with a lot of assumptions.
If the stock is overvalued, a fundamental investor would typically believe that the price will soon fall to their estimates, and if it’s undervalued, they’ll expect the stock to increase in value.
The whole point of fundamental investing is to look for ‘hidden gems’ that are undervalued and avoid ones that are overvalued.

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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.