In this article, we'll discuss the reverse discounted cash flow (DCF) analysis, a valuation method that provides insights into market expectations for a company's growth. This approach starts with a company's current stock price and works backward to determine the growth rate implied by that price. The reverse DCF is particularly valuable for high-growth companies, volatile markets, or when forecasting cash flows is challenging, as it reveals growth expectations priced into the stock.
This article will explain the reverse DCF method and compare it to standard DCF. We'll then provide a step-by-step example with a real company, including a free Excel template, and discuss key limitations of this valuation technique.
To understand the reverse discounted cash flow (DCF), we first need to explain the standard DCF method.
DCF is an absolute valuation method used to estimate the intrinsic/fair value of a company based on its expected future cash flows.
Here are the key steps of the DCF valuation process:
Thus, the DCF method estimates a company's value by projecting and discounting its future cash flows to the present.
The reverse DCF inverts this process. It starts with the current stock/market price and works backward to determine the growth rate implied by that price. This approach helps investors understand what growth expectations are built into the company's current stock price.
Here are the key steps of the reverse DCF valuation process (after a standard DCF model has been built):
The resulting implied growth rate represents the market's expectations for the company's future performance. Investors can then analyze this rate to determine if it's achievable based on their understanding of the business, while considering the company's historical performance, industry trends, and competitive position.
Notably, the reverse DCF offers several advantages over the standard DCF approach:
Despite these advantages, it's important to note that the reverse DCF, like any valuation method, has its limitations. The accuracy of the analysis, like the DCF, still depends on the chosen discount rate, terminal growth rate, and number of years in the forecast period. Moreover, the model assumes a constant annual growth rate over the forecast period, which may not reflect real-world variability in a company's growth trajectory.
We'll discuss these limitations, and others, in the final section of this article.
To demonstrate how to apply the reverse discounted cash flow (DCF) to evaluate a company's current stock/market price, we'll use Cloudflare (NET) as our example company. Cloudflare provides a suite of web performance and security services, including content delivery network (CDN), DDoS protection, and internet security solutions, to businesses through a freemium and subscription-based pricing structure.
Cloudflare is a suitable candidate for the reverse DCF, given that it's a non-dividend paying company, which means that it can reinvest all excess cash for growth. Moreover, because the company recently achieved positive free cash flow (FCF) in FY 2023, this provides a solid starting point for future cash flow projections, eliminating the need to estimate when the company will turn FCF positive.
As a high-growth technology company that has only recently achieved positive operating cash flows, forecasting these cash flows is inherently more challenging and prone to errors. This makes a reverse DCF particularly useful for Cloudflare, as it allows us to work backward from the current market price to understand implied growth expectations.
Here's the steps investors can follow to complete a reverse DCF valuation for any company, as explained in greater detail in the following sections:
In short, the reverse DCF process involves building or using an existing DCF model, then adjusting the FCF growth rate in the model over the forecast period until it matches the intrinsic share price.
Therefore, if you're already familiar with the DCF model, you can skip to the final step to understand the reverse DCF process. The steps below will not be in-depth, as the focus is on understanding the reverse DCF process, not every nuance and detail of the DCF model.
Investors can use the spreadsheet linked below to follow along for the Cloudflare reverse DCF example:
The first step in conducting a reverse DCF is to calculate the company's current free cash flow (FCF0). This serves as the foundation for future cash flow projections.
A simple and conservative approach to calculate the company's free cash flow is to subtract total capital expenditures (CapEx) from operating cash flow, as shown in the formula below:
Free Cash Flow (FCF) = Operating Cash Flow - Total Capital Expenditures (CapEx)
This FCF formula captures the cash generated from operations and subtracts the cash spent on long-term investments in the business, effectively representing the company's available cash after necessary investments.
Operating cash flow and CapEx can be pulled from the company's cash flow statement, available on the company's investor relations pages or through the Securities and Exchange Commission (SEC), via the company's 10-K Annual Statement.
Here's Cloudflare's cash flow statement with these two items outlined:
In FY 2023, Cloudflare reported $254,406K in net cash provided by operating activities and -$114,396K in purchases of property and equipment. Note that "purchases of property and equipment" mean the same thing as total capital expenditures.
It's important to normalize FCF to account for any one-time events or unusual expenses that may not recur. However, to keep things simple, we'll calculate Cloudflare's current FCF as follows:
Note that it's important to normalize free cash flow to account for any one-time events or unusual expenses that may not recur. However, to keep things simple, we'll calculate Cloudflare's current FCF as follows:
Free Cash Flow [NET; FY 2023] = $254,406K - $114,396K --> $140,010K
This $140,010K represents the amount of cash Cloudflare generated from its core business operations after accounting for capital expenditures in FY 2023.
The next step is to determine the number of years in the forecast period, typically ranging from 3 to 10 years. This step is necessary as it sets the timeframe for our cash flow projections.
Shorter forecast periods are often used for more stable companies, while longer periods may be appropriate for high-growth companies or those in rapidly changing industries because their cash flows are expected to change more significantly over time.
For Cloudflare, we'll use a 5-year forecast period. This is appropriate given the company's high growth profile and its recent achievement of positive FCF, balancing the need for a longer projection period with the increased uncertainty of forecasts further into the future.
Next, we need to estimate the annual rate at which FCF will grow over the forecast period. For the reverse DCF to work, we must assume a constant annual growth rate, which is a limitation of this approach. An exception would be if you build an integrated free cash flow to the firm (FCFF) model, but even then, you'd still be assuming constant top-line revenue growth.
There are several ways to base your estimate future FCF growth, including:
Since Cloudflare only became FCF positive in FY 2023, analyzing historical FCF growth rates isn't very useful. Moreover, analyst estimates for FCF growth are difficult to access and may not be helpful.
Instead, we'll assume a 20% year-over-year growth for the company's FCF. This seems reasonable, and even potentially conservative, given that the company has been effectively doubling its operating cash flow every year since FY 2021, without significant changes to its CapEx.
Note that for a reverse DCF, you don't actually need to estimate a growth rate to begin with. The goal of a reverse DCF is to find out what growth rate the current stock price suggests. However, it's still helpful to include an initial growth rate in your DCF model as a starting point. This lets you compare the growth rate implied by the market (which you'll calculate later) with a more conservative or realistic estimate.
The next step is to estimate the discount rate, which represents the required rate of return an investor expects on their investment. This step assesses the relationship between risk and return for the investment.
This can be based on your personal required rate of return or, more conventionally, the Weighted Average Cost of Capital (WACC). The WACC is the average rate of return a company is expected to pay its security holders to finance its assets, incorporating both equity and debt.
Instead of using the somewhat flawed WACC, we'll estimate our required rate of return by estimating a risk premium that can be added to the U.S. risk-free rate, as shown in the formula below:
Discount Rate = Risk-Free Rate + Risk Premium
The risk-free rate represents the return on an investment with zero risk of financial loss, commonly represented by the 10-year U.S. Treasury Note, which is considered "risk-free" because it's backed by the full faith and credit of the U.S. government. The risk-free rate provides a baseline for comparing the risks of more speculative investments, including stocks like Cloudflare. Currently, this rate is 4.25%.
Given that an investor in Cloudflare, a high-growth technology company, would likely be risk-seeking and expect an outsized return, and considering the market's recent high interest and inflation, it's reasonable to assign a 6% risk premium to this discount rate. This premium represents the additional return an investor seeks for investing in Cloudflare stock over a risk-free asset like the 10-year U.S. Treasury Note.
Therefore, the discount rate used in our model will be calculated as follows:
Discount Rate [NET] = 4.25% + 6.00% --> 10.25%
The 10.25% discount rate means that an investor expects a 10.25% return on their investment in Cloudflare, reflecting both the baseline risk-free rate and the additional risk premium.
The next step is to estimate the terminal value, which represents the value of the company's cash flows beyond the forecast period.
We can use either the exit multiple approach or the perpetual growth approach to estimate the terminal value, as defined below:
For Cloudflare, we'll use the perpetual growth rate approach, as it's suitable for companies with long-term growth prospects.
The perpetual growth formula, also known as the Gordon Growth Model (GGM), estimates terminal value by using the formula shown below:
where:
This formula assumes that the company's free cash flow will grow at a constant rate indefinitely. Note that "FCFn" represents the last year of the forecast period (the 5th year forecasted FCF in our example).
Using a terminal growth rate of 2%, which is below our discount rate (10.25%) and the nominal growth rate of the U.S. economy (currently ~5.4%) to ensure realistic valuations, we can solve for Cloudflare's terminal value:
TV [NET] = $348,390K × (1 + 0.02) / (0.1025 - 0.02) --> $4,307,363K
The terminal value of $4,307,363K represents the present value of all future cash flows beyond our 5-year forecast period.
The next step in a DCF is to calculate the present value of FCFs by dividing each year's projected cash flow by the company's discount factor, which represents the compounded discount rate over time, as shown in the formula below:
Present Value of FCFs = Projected FCF / (1 + re) n
where:
Note that the discount factor for the terminal value is the same as for year 5. This present value calculation should be repeated for every year of the forecast period and the terminal value.
Here's how our reverse DCF Excel model looks at this point:
Summing these present values gives us the enterprise value of $3,553,530K. The enterprise value represents the total value of a company, including both its equity and debt. To bridge to equity value, which represents the value of the company available to shareholders, use the formula below:
Equity Value = Enterprise Value + Cash and Cash Equivalents + Short-Term Investments - Total Debt - Minority Interest
Here's the completed equity value calculation using the enterprise value and relevant information sourced from Cloudflare's FY 2023 balance sheet:
Equity Value [NET; FY 2023] = 3,553,530K + 89,386K + $1,586,880K - $1,321,713K - $0K --> $3,908,083K
Thus, the fair value of Cloudflare's equity is estimated to be $3,908,083K, according to our DCF valuation.
Now, if we divide the equity value by the diluted shares outstanding of 333,656K (which accounts for potential dilution from stock options and convertible securities), we get an intrinsic share price of $11.71 ($3,908,083K / 333,656K).
We can also consider a margin of safety to account for uncertainties and errors in our DCF valuation. For instance, applying a 15% margin of safety for our Cloudflare example gives us a buy price of $9.96 ($11.71 × (1 - 15%)).
Finally, the stock's valuation can be interpreted as follows:
Here's how the final part of the DCF model is outputted in our Excel model:
Given Cloudflare's implied buy price of $9.96 and its current stock price of ~$78.60, this suggests the stock is significantly overvalued based on our model and assumptions.
Now that we've built a straightforward DCF model, we can complete the reverse DCF by adjusting the FCF growth rate until the intrinsic share price (or buy price, if considering the margin of safety) equals the current stock price of $78.60.
This adjustment can be done manually or using Excel's Goal Seek function. Goal Seek is a built-in Excel tool that allows you to find the input value needed to achieve a desired result in a formula.
When adjusting the growth rate, remember that if the intrinsic/buy price is less than the stock price, you should increase the FCF growth rate, and vice versa. This relationship exists because higher growth rates lead to higher valuations, and lower growth rates result in lower valuations.
To use Goal Seek in Excel, navigate to "Data" on the Excel ribbon --> click on "What-If Analysis" --> select "Goal Seek." Then, in the Goal Seek dialog box, input the following for our Cloudflare example:
The image below shows the completed reverse DCF model and how to setup the Goal Seek function in Excel:
After running the Goal Seek function, our reverse DCF model implies that to justify Cloudflare's current stock price of $78.60 (ignoring our 15% margin of safety), the company needs to grow its FCF by 83% annually over the 5-year forecast period. The completed reverse DCF valuation model is shown below:
Therefore, if you believe Cloudflare can sustainably achieve this 83% annual FCF growth rate and you're satisfied with a 10.25% annual return, then the stock could be considered reasonably priced at its current level.
However, realistically, an 80%+ FCF growth rate is an exceptionally high expectation for any company, even in the high-growth tech sector. Therefore, our reverse DCF suggests that Cloudflare's stock is likely significantly overvalued at its current price, unless the company can deliver extraordinary growth in the coming years.
While the reverse DCF can provide valuable insights into market expectations, it's important to understand its limitations. These constraints can affect the accuracy and reliability of the analysis, as discussed below:
The reverse DCF's limitations highlight the importance of using it as part of a broader valuation analysis. While it's useful at revealing market growth expectations, it should be complemented with competitive assessments, industry analysis, and other valuation methods. For instance, comparing the reverse DCF results with a comparable company analysis (comps) can provide a more comprehensive view of a stock's valuation relative to both its intrinsic value and its peers.
The reverse discounted cash flow (DCF) is a valuation technique that works backward from a company's current stock price to determine the growth rate implied by the market. It's particularly useful for understanding market expectations, especially for high-growth or volatile companies where forecasting future cash flows is challenging.
Here's the high-level approach to applying a reverse DCF:
The resulting growth rate reveals what the market expects from the company. Investors can then assess whether these expectations are realistic based on the company's prospects and industry dynamics.
Key limitations include inheriting most DCF limitations (except the need to forecast FCF growth), assuming a constant growth rate over the forecast period, and relying on the current stock price being an accurate reflection of the company's value.
Despite these constraints, the reverse DCF serves as a valuable tool when used alongside other valuation methods and qualitative analysis, providing insights into market sentiment and potential mispricing of stocks.
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