As a professional investor, I always use a reverse DCF to value a company. It’s the best way to think about valuation. I’ll teach you everything you need to know in this article.
I just wanted to take a moment to express my gratitude for your latest article on valuing companies using a reverse DCF analysis. Without a doubt, it’s one of your best in my opinion! As always, the quality and depth of your content are unmatched, and I can't thank you enough for sharing your expertise with us.
I know I’ve said this before but it’s worth repeating that you have a true gift for teaching, my friend. The way you break down complex concepts into easily digestible pieces is simply remarkable. Your ability to make even the most daunting topics approachable and understandable is something I truly admire.
But it's not just the knowledge you impart that makes your articles stand out. Your writing style is engaging, relatable, and very enjoyable. You have a knack for making even the driest subject matter entertaining, and I find myself eagerly devouring each word you write.
So, thank you, CQ, for your exceptional work. I appreciate the time and effort you put into crafting such informative and engaging articles. You've made a genuine impact on me and countless others who have had the privilege of reading your work.
Keep up the fantastic work, and I'm eagerly looking forward to your next article!
I second this. Even more so since I believe English is your second language. Wonderful mastery of the language. It's no easy feat making complex topics seem so simple. Bravo!
Thank you for posting this article - it’s excellent. I’m still trying to wrap my head around it but a few of beginner’s questions for you:
1. Why do you use the gdp growth as the long term in perpetuity growth rate?
2. With respect to the targeted expected return e.g of 9% - just checking this means the expected growth in share price based on number of current shares outstanding? (Ie it doesn’t take into account dividends etc).
3. Finally - in the final apple example - just want to confirm we are looking at the fcf growth rate the market is pricing in for the 9% return (share price growth) we are hoping to achieve as an investor.
1. When you would use a growth rate higher than GDP growth, the company would over time become bigger than the economy, which is impossible. The lower the perpetuity growth rate in your model, the bigger your margin of safety. I would suggest to use a perpetuity growth rate between 2% and 3.5%
2. This is the return you'll achieve as an investor when your assumptions were correct. We are using free cash flow so this is the total return you will achieve (dividends need to be paid from the FCF). If you used 9%, you'll generate a return of 9% per year as a shareholder
Thanks for the valuable article. Your way of explanation is simple to understand for layman investor.
I'm very sure there are many guys in investor community around the world thankful to your outstanding efforts on financial literacy. Many thanks & keep continuing your journey. I wish you the very best & will be life long student of Compounding quality .
Thank you very much for writing and publishing this most insightful and useful article. It solidifies my understanding and use of both DCF and Reverse DCF, and is written plainly, which I appreciate. I will surely recommend and share this article and your other useful articles with others.
I'm professional in corporate finance, I've read this article with interest but with incredulity too, you know, I have studied complicated formulas and processes to calculate the value of a company or a project, so this article show a really easy and simplified way to make a really good calculation, this article it's really valuable for many people!, Great job!
I want to express my sincere appreciation and gratitude for the incredible amount of valuable tips and informative posts you have been sharing lately. Your dedication is truly admirable.
I have a question regarding the reverse DCF analysis for companies that are not yet generating positive free cash flow. In such cases, would it be appropriate to utilize sales as a metric instead? I'm curious to know your thoughts on this matter.
Thank you once again for your unwavering commitment and hard work!
When a company has a negative FCF because it is investing heavily in future growth, you can take earnings instead of FCF.
However, when a company isn't generating FCF/Earnings yet, a reverse DCF doesn't have much value. I wouldn't use sales into this model because only a small fraction of sales is translated into FCF in the end.
What you could do instead is make an estimation about how much revenue the company would generate in 10 years and how much profit they would generate from that revenue.
For example: you think company X will generate $1 billion in revenue in 10 years and it will be able to translate 10% of revenue into FCF. In this example, the company would generate $100 million in free cash flow in year 10.
Now let's say that the company has a market cap of $500 million today. In that case, the company would trade at a FCF yield of 20% in 10 years when your assumptions are correct. When you make the assumption that a FCF yield of 5% is fair for this company, your return would be 400% when you buy this company today.
The above is just a rule of thumb and I wouldn't make investment decisions purely based on this. It's way riskier to invest in companies which aren't profitable yet so your margin of safety should be way higher.
Hey CQ,
I just wanted to take a moment to express my gratitude for your latest article on valuing companies using a reverse DCF analysis. Without a doubt, it’s one of your best in my opinion! As always, the quality and depth of your content are unmatched, and I can't thank you enough for sharing your expertise with us.
I know I’ve said this before but it’s worth repeating that you have a true gift for teaching, my friend. The way you break down complex concepts into easily digestible pieces is simply remarkable. Your ability to make even the most daunting topics approachable and understandable is something I truly admire.
But it's not just the knowledge you impart that makes your articles stand out. Your writing style is engaging, relatable, and very enjoyable. You have a knack for making even the driest subject matter entertaining, and I find myself eagerly devouring each word you write.
So, thank you, CQ, for your exceptional work. I appreciate the time and effort you put into crafting such informative and engaging articles. You've made a genuine impact on me and countless others who have had the privilege of reading your work.
Keep up the fantastic work, and I'm eagerly looking forward to your next article!
Warmest regards,
Wow. You make me blush, Pavel!
It's a true honor to write for people like you. It's one of the reasons why I get up excited in the morning!
Ditto :)
Adding to the list of grateful people. Your writtings helped me build a solid yet straightforward framework for investing. I thank you for that.
Thank you very much, Nava!
Thank you, Simon!
I second this. Even more so since I believe English is your second language. Wonderful mastery of the language. It's no easy feat making complex topics seem so simple. Bravo!
Thank you, Sayre! It's a true honor!
Hello
Thank you for posting this article - it’s excellent. I’m still trying to wrap my head around it but a few of beginner’s questions for you:
1. Why do you use the gdp growth as the long term in perpetuity growth rate?
2. With respect to the targeted expected return e.g of 9% - just checking this means the expected growth in share price based on number of current shares outstanding? (Ie it doesn’t take into account dividends etc).
3. Finally - in the final apple example - just want to confirm we are looking at the fcf growth rate the market is pricing in for the 9% return (share price growth) we are hoping to achieve as an investor.
That’s it. Thank you for your help
1. When you would use a growth rate higher than GDP growth, the company would over time become bigger than the economy, which is impossible. The lower the perpetuity growth rate in your model, the bigger your margin of safety. I would suggest to use a perpetuity growth rate between 2% and 3.5%
2. This is the return you'll achieve as an investor when your assumptions were correct. We are using free cash flow so this is the total return you will achieve (dividends need to be paid from the FCF). If you used 9%, you'll generate a return of 9% per year as a shareholder
3. That's correct
Thank you CQ.
Thanks for the simple and instructive article. As always great content
It's an honor, Michele!
Hi QC,
Thanks for the valuable article. Your way of explanation is simple to understand for layman investor.
I'm very sure there are many guys in investor community around the world thankful to your outstanding efforts on financial literacy. Many thanks & keep continuing your journey. I wish you the very best & will be life long student of Compounding quality .
Thanks,
B Nair
It's an honor, Nair!
I am seriously considering leaving my job to teach investors on this website full time. It would be my Ikigai!
Спасибо огромное))))
Очень полезно и интересно!
Great stuff
Thank you, World System!
Great article mate. Very well explained and easy to understand with the excel sheet. Thank you.
Thank you, Aashish!
If you want me to cover a certain topic in the future, just let me know.
Wonderful articles, filled with information, and wisdom. I read every article that comes tome. Thank you.
It's for comments like this that I am writing 2 new articles per week. Thank you, Skip!
It will never cease to amaze me how this information is not taught in school.
Absolutely. If they was a mandatory course about financial course and investing in every school, the world would be healthier and wealthier place.
Thanks for sharing
It's an honor, Majed!
Thank you very much for writing and publishing this most insightful and useful article. It solidifies my understanding and use of both DCF and Reverse DCF, and is written plainly, which I appreciate. I will surely recommend and share this article and your other useful articles with others.
That would be the greatest honor, Eric!
Feel free to use the Excel to make the calculations for your own companies.
Hi Compounding Quality, I've been looking forward to your explanation of the Reverse DCF for weeks so many thanks for sharing this.
It's an honor, Kevin!
I hope it wasn't too complex and you were able to understand everything.
I'm professional in corporate finance, I've read this article with interest but with incredulity too, you know, I have studied complicated formulas and processes to calculate the value of a company or a project, so this article show a really easy and simplified way to make a really good calculation, this article it's really valuable for many people!, Great job!
It's a true honor. Thank you very much, Carlos!
What would we do without you???? I hope all the comments are a small glance through the window as to how much we appreciate you. Thank YOU CQ!!!
The honor is all mine, Joey! I'm so blessed to have readers like yourself. It makes me jump out of bed every single morning!
Thanks for also sharing the Excel templates.
The honor is mine!
Hello CQ,
I want to express my sincere appreciation and gratitude for the incredible amount of valuable tips and informative posts you have been sharing lately. Your dedication is truly admirable.
I have a question regarding the reverse DCF analysis for companies that are not yet generating positive free cash flow. In such cases, would it be appropriate to utilize sales as a metric instead? I'm curious to know your thoughts on this matter.
Thank you once again for your unwavering commitment and hard work!
Best regards,
S
It's a true honor, Dr. Wolf!
When a company has a negative FCF because it is investing heavily in future growth, you can take earnings instead of FCF.
However, when a company isn't generating FCF/Earnings yet, a reverse DCF doesn't have much value. I wouldn't use sales into this model because only a small fraction of sales is translated into FCF in the end.
What you could do instead is make an estimation about how much revenue the company would generate in 10 years and how much profit they would generate from that revenue.
For example: you think company X will generate $1 billion in revenue in 10 years and it will be able to translate 10% of revenue into FCF. In this example, the company would generate $100 million in free cash flow in year 10.
Now let's say that the company has a market cap of $500 million today. In that case, the company would trade at a FCF yield of 20% in 10 years when your assumptions are correct. When you make the assumption that a FCF yield of 5% is fair for this company, your return would be 400% when you buy this company today.
The above is just a rule of thumb and I wouldn't make investment decisions purely based on this. It's way riskier to invest in companies which aren't profitable yet so your margin of safety should be way higher.