Clay Finck (03:00):

Imagine that I walked up to you and told you that I had a money machine that I wanted to sell you, and I wanted to sell it to you for $100. Well, the first thing you would probably say back to me is, “Well, how much money does the money machine actually produce?” That’s a great question because how much money the machine produces helps determine what the true value or the intrinsic value, as Buffett would call it, of that machine is actually worth. Then I might tell you that the machine produces $15 per year. Then you might want to know, “Okay, well, how long does that persist? Does it persist for a year? Does it persist for two years, 10 years, forever? How long is it going to produce that $15?”

Clay Finck (03:41):

Now showing this example helps paint a picture in telling what the variables are, and it’s determining the intrinsic value of the money machine. If the money machine produces $15 per year, let’s assume it produces it for 10 years, and then it doesn’t produce anything after that first 10 years. So we are going to project out all those cash flows of the money machine to help determine what the value of it is today.

Clay Finck (04:07):

Over the 10-year period, the money machine produces a total of $150, but the value of the final $15 payment in 10 years isn’t the same as $15 today because of the time value of money. People value money more today than they do in the future all else equal. Additionally, the value of the dollar, as we all know, is declining year after year because of inflation. This is where the discount rate comes into play. Historically, many people have used the 10-year Treasury rate as their discount rate, which is 2.7% at the time of this recording. I personally don’t like using that to value a company because if the Treasury rate happens to go up to 4% or 5%, then the intrinsic value drastically decreases because interest rates are like gravity. When interest rates rise, the value of financial assets decline. When interest rates drop, the value of financial assets rise.

Clay Finck (05:05):

Another reason I don’t like using the 10-year Treasury as my discount rate is because inflation is much higher today than that interest rate, which usually isn’t the case. It’s kind of unique to today. This is a very important concept to understand. If you’re discounting your cash flows at 3% but the value of your cash flows are declining because of inflation by, say, 10%, then you’re assigning more value to those cash flows than what they’re actually worth.

Clay Finck (05:35):

For those who want to use a discounted cash flow model but not use the 10-year Treasury rate, some choose to use what they call a hurdle rate. Some people have a 10% or 15% hurdle rate that they want all of their investments to achieve that they can use to determine if they want to invest in it or not, and they’ll use that as their discount rate. Sometimes people will use different discount rates for different investments or different hurdle rates for different investments. It might be appropriate to use a 15% discount rate on riskier investments and a 10% rate on more conservative investments to help account for that additional risk with some companies. That’s because the cash flows of a company like Tesla are more uncertain, and they’re a bit riskier than other businesses such as Walmart or those stable companies that have been around for a long time.

Clay Finck (06:24):

Let’s say that we used a 10% hurdle rate and the price I offer you for the money machine is $100. If the intrinsic value we calculate for the money machine is less than $100, then we wouldn’t want to buy it because we calculated the intrinsic value or the value of the money machine to be less than $100. If the intrinsic value we calculate is above $100, then we would want to buy it because the price is less than what we believe the value is worth.

Clay Finck (06:53):

Back to the money machine example. There are a lot of discounted cash flow models out there on the web that can help you calculate the intrinsic value, but I’m going to link the one I’m using that Preston and Stig put together on buffettsbooks.com. Once you understand how a DCF model works, you could even build a simple one yourself in Microsoft Excel or Google Sheets. It’s actually fairly simple. I’ll link the model I’m using on buffettsbooks.com and the show notes if anyone is interested in using it themselves.

Clay Finck (07:24):

Essentially, all a discounted cash flow model is doing is projecting out the cash flows of what we’re valuing into the future, and then discounting those cash flows back to today using the discount rate or, in other words, the interest rate we’re going to enter into our model. So if you projected out all the cash flows into the future for our money machine and discount them back to today, you’ll come up with the intrinsic value which you can then use to compare to the price you’re offered to determine if you want to buy that asset or buy that money machine or not. Or you can use that to compare your one investment to your other investment opportunities.

Clay Finck (08:02):

So the first input into the model on the website is the earnings per year. I mentioned earlier that that is $15 per year. Then it asks what rate we can expect the earnings to grow. I put zero percent because it produces the same amount every year in this example. Then our calculator asks for the discount rate, and we’re going to use a discount rate of 10% as our hurdle rate we want our investment to achieve. Then finally it asks how many years those cash flows will run, and I put 10 years. Then on their calculator, it shows that the sum of the discounted cash flows from the first 10 years is equal to $92. I mentioned earlier that over the lifetime, the money machine will produce a total of $150. That’s $15 over 10 years, 15 times 10 is 150. But after discounting all of those cash flows to today at a rate of 10% per year, the total value we come up with is only $92.

Clay Finck (09:01):

Just as a couple examples, the $15 cash flow at the end of year one is discounted back to $13.64 today, and the cash flow at the end of year 10 is only worth $5.78 as of today. So that kind of shows the power of that money compounding over time, and it’s discounted in this example back to today. Because the value of $92 for the money machine we come up with is less than the $100 that you were offered to buy it, then you shouldn’t purchase it because it’s trading at a price above what you believe it’s worth.

Clay Finck (09:36):

Now, if you were satisfied with, say, a lower rate of return, say 8%, then it’s likely that $100 would be a fair price to pay for the stock, price to pay for the money machine. So the hurdle rate you determine is really important if you’re using a discounted cash flow model. To help illustrate how important the discount rate is, I also wanted to run a discount rate of 2.7% through the model as well. Using a discount rate of 2.7%, which is the 10-year Treasury rate, this increases the intrinsic value of the money machine from $92 all the way to $130. So if you were satisfied with a 2.7% return, then you’d be willing to pay up to $130 for the money machine. For me, that is a pretty lousy return.

Clay Finck (10:22):

Now, you can take the money machine example and apply it directly to stock investing as well because stocks consist of companies that are producing earnings and producing cash flows or, in other words, producing money just like how the money machine was producing money every year. So businesses, you can think of them as money machines. I think it’s really important for people to understand these concepts when they’re looking into investing in individual stocks.

Clay Finck (10:47):

I might have someone tell me that Tesla’s stock should be worth $4,000 per share, way higher than it is today. Well, if you ask that person what discount rate they’re using in calculating that value, they might wonder what the heck you’re talking about. I could come up with any value for Tesla stock that you want me to. It all just depends on whatever discount rate I enter into my model. If I’m satisfied with a 0.5% return, then maybe Tesla stock is worth $4,000 per share. But 0.5% is a really, really bad return, and I shoot for a much higher return, more like 10% or 15%. This is what people are kind of getting at when they say your future expected returns on stocks increase when stock prices go down, and your expected future returns decrease when stocks go up. So in the DCF model, we are calculating what we think the value of a company is based on the company’s future free cash flows.

Clay Finck (11:44):

Now, the other method I like to use is calculating the internal rate of return or the IRR of the company. Instead of calculating the present value of all the free cash flows, you can just enter the price of the stock today into an IRR model, and it will calculate your expected return based on if you purchased the stock at today’s price. This means that you don’t have to worry about entering the discount rate yourself. I like this method because we already know the price of the stock today. So I think it’s helpful to just use that information that we already know and use it to our advantage in trying to calculate what sort of return we can get out of the company.

Clay Finck (12:23):

The TIP Finance Tool on our website, theinvestorspodcast.com, actually has a free IRR calculator that anyone can use. I love using it when I analyze stocks that I think might be a good deal. During this episode, I’m going to be walking through analysis of Google stock using the TIP Finance Tool. If you want to pull up the tool, it might be easier to follow along as I talk through this, but it’s by no means of requirement.

Clay Finck (12:49):

In the TIP Finance Tool, I pulled up Google stock. At the time of this recording, it’s trading at around $2,230 per share. First, we have to determine at what growth rate we expect Google’s cash flows to grow into the future for the next 10 years. After looking through the past decade, I think a 10% growth rate is a fairly conservative assumption. The model allows you to enter three different growth assumptions with different probabilities on those growth rates. I just decided to keep it simple in this example and enter a 10% growth rate with 100% probability and leave the other entries at zero percent just for simplicity’s sake. Google has grown much higher than that in the past decade. But after looking through the numbers, I decided that a 10% growth rate was a fairly conservative assumption for this simple example.

Clay Finck (13:42):

The next entry is our starting point for the free cash flows. If we leave this blank, then it will use the free cash flow that the company generated in the past 12 months, which right now is almost $69 billion. This is a drastic increase over the past couple years, so I’m going to try and be a little bit conservative and say that the starting point is $60 billion. If we were to enter a recession, then we could see a substantial short-term decrease in this. So we should account for the potential for this to be lower to try and be a little bit conservative in our assumptions here.

Clay Finck (14:17):

The next entry is the number of shares outstanding at the end of 10 years. The TIP Finance Tool shows that there’s 664,000 shares outstanding at the end of 2021. I assumed that Google would buy back about 1% of their shares every year. Which doing some quick math, after 10 years that would mean there are 600,000 total shares at the end of 10 years. Again, I just assumed that they’d buy back 1% of shares over the next 10 years. I expect it honestly to be a lot higher than that. They’ve been buying at a bit faster pace recently. Again, I wanted to be a bit conservative here, so I assumed that they’d buy back 1% of shares per year. At the end of 10 years, the entry I put is 600 or 600,000 total shares.

Clay Finck (15:04):

Now with all of these inputs, this produces a 7.5% expected return for Google stock assuming you bought it at today’s price of $2,230 per share. One of the reasons I was interested in Google is because they’ve had a recent pullback. It looks like they topped out at around $3,000 per share, so it’s currently trading about 25% below where it topped out at the end of 2021. What the model is doing is projecting out the future free cash flows for Google, and then discounting those to today and comparing it to the price of the stock, which is, again, $2,230 per share. To get back to that $2,230 per share today, we need to discount those cash flows at 7.5%, which is how the model came up with that expected return.

Clay Finck (15:58):

Now, I’d like to tweak some of the variables to show you how it affects the expected return of our investment because we’re kind of just trying to make conservative assumptions. It’s nice to mess around with some of the variables to see how that changes our expected return. If Google stock were to decline to, say, $1,900 per share next week and we purchased it then, this increases our expected return from 7.5% to 9%. Like I mentioned before, as the stock price falls, our expected return goes up assuming our assumptions in the model hold true, which is a really key assumption. If Google ramped up their share buyback program and instead of purchasing 1% of shares over the next decade, they purchased 3% per year, which would be a huge increase, that increases our expected return from 7.5% to 9.3%. If Google’s free cash flows grew by 15% a year over the next decade instead of 10%, that increases our expected return from 7.5% to 10.5%.

Clay Finck (17:02):

Once you get a good idea of what your expected return is on a company, you can then use that and compare it to other investments you’re interested in. So if you find two similar companies with similar risk levels that you want to add to your portfolio, you can use your IRR model to compare your opportunity costs between the two. If company X produces a return of 8% but company Y has a expected return of 12%, then you’d want to invest in company Y because you’re going to get more for your money, assuming that the risk between the two is similar. You’d expect a higher return on a riskier investment in general.

Clay Finck (17:38):

Now, all of the assumptions in the DCF model or IRR calculation are important, so it’s really important that you’re able to come up with conservative assumptions. If it requires really high growth rates and the earnings to hit a return that works for you, then there might be a good chance that you’re being a bit too optimistic in your assumptions.

Clay Finck (17:57):

Another piece I wanted to mention is that you’re really sure that the company has a durable, competitive advantage. A company with a strong moat and a strong competitive advantage ensures that the cash flows you’re projecting into the future are durable and they’re going to be growing over time. If a company doesn’t have a strong moat, then you’re not able to project out those cash flows five or 10 years into the future with confidence as another company might come in and disrupt them. This is why Buffett is so big on companies that have a strong moat. Then he’s comfortable holding that company for a long time.

Clay Finck (18:31):

Coca-Cola is a prime example for Buffett. He bought Coca-Cola back in 1988. Because he recognized that strong brand and the strong moat the company had, he’s been able to hold it for a very long time. Now it’s been 34 years. Back in 1988, the revenues for Coca-Cola were $8.1 billion, and today it’s all the way up to $40 billion in revenues per year. It just goes to show that Buffett was able to see that really strong moat they had because many companies do not last that long, let alone grow by that much.

Clay Finck (19:04):

Outside of the DCF and IRR calculations, one could also look at other metrics such as the price-to-earnings ratio or the price to free cash flow. These metrics vary by industry and by company. One thing I like to do is look at how that ratio has changed over time for the company. Sometimes you’re able to see that the ratio moves up and down over the past, say, 10 years, and you can see how the company has traded over time. When it’s in the lower end of the range, you might find a really good time to buy. That’s another metric I like to look at when determining if something is over or undervalued or if it’s trading in a range that’s normal over its past history.

Clay Finck (19:46):

That’s all I had for today’s episode. I hope you guys learned something about how to value a company and you found value in this episode. If you guys have any questions relates to anything I discussed, feel free to reach out to me. I’d be happy to try and help you. My email is clay@theinvestorspodcast.com. On Twitter, my username is @Clay_Finck. Feel free to DM me there. My DMs are open at C-L-A-Y, underscore, F-I-N-C-K. I’ll be sure to get back to you when I have a chance. Again, I’d be really happy to help you guys out. Thanks for tuning in, and we’ll see you again next time.

Outro (20:22):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin, and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.