Investors always struggle with the question: What is the fair value of the company I am tracking? Reverse DCFs are a simple tool to make this easier. It may sound fancy but it is very easy to do. I am going to assume that you already know valuation for this post. If you don’t, you can learn here. You can find my excel files at the bottom here.
Reverse DCFs are nothing but back calculating the growth rates from the current market price. What do I mean by that? I am picking up Hero MotoCorp as an example here. I first value the company like I normally would, projecting out growth rates in revenue, operating margins and reinvestment by the company. These 3 are the biggest factors in valuations of a company along with discount rates. At the time I valued Hero MotoCorp, the market price was Rs. 2894. Say I get a value of Rs. 2200. Now most investors’ first instinct would be that they may have done something wrong, maybe I can push up the growth further, lower capex, etc. etc. We play all kinds of games. Maybe we just say the company is overvalued and give up. Maybe we think the market must know something we don’t. It is anxiety inducing.
This is where Reverse DCFs come in. According to my assumptions, the value must be 2200. It is fine. But what we can do is use the power of excel to run different scenarios. What do I mean by that? Say I assumed revenue would grow by 10% CAGR for next 5 years. But I don’t really know, I am just guessing. So I type =randbetween in excel and give it a range of 4–12%, which I think is reasonable. I do the same for operating margins and capex.
So Revenue growth rate: Between 4%-12%
Operating Margins: 14% Mean with 4% SD
Capex: 2%-6.5% of Sales
I arbitrarily made my judgments in giving these ranges above. I don’t know. You don’t know. Nobody knows. Then I let excel run the different combinations of these numbers to give me 10000 values for the company stock. Again, 10000 is a randomly chosen number. You can run more combinations if you want. It is easy using data tables in excel. I’ll attach my file too.
Now we finally get to the point of Reverse DCFs. I have a table like this in front of me:
This whole table of 10000 possible values is in front of me. I need to find out what the market is pricing in for the company. So I just go to value per share and run the filter: Show all values between 2800–2900. You can play with this. You can then explore the range of growth rates, margins and capex on your own. The number of values you will have will keep reducing. It will finally look something like this:
It is pretty cool. Now you can make your own judgement on the what the market is pricing in. Do you think what the market is pricing in is reasonable? Maybe the market is overly optimistic. Maybe it is not. I know I have thrown a lot of subjective decisions in front of you, but then all investing is subjective and risky. We have to do our own research and make our best decisions. I hope you find this useful and Reverse DCFs make your life simpler.
You can find my excel sheets here.
