Per How to Make Money Picking Stocks, our models focus on quantifying the expectations for future cash flows embedded in the market price or any target price. Our goal is to help clients identify and measure differences between their expectations for future cash flows and the marketâ€™s expectations.

This post explains how we use our dynamic discounted cash flow model to quantify expectations for future cash flows.

In Figure 1, we compare bond valuation with stock valuation to show how the relevant terms correspond to each other. Equity cash flows, for example, mirror fixed income coupon payments. The Growth Appreciation Period for stocks is analogous to the maturity date for bonds. Market risk for bond investors comes from interest rate fluctuation. Market risk for equity investors is quantified by the Weighted-Average Cost of Capital (WACC), which quantifies the risk assigned to the stream of cash flows.

The key difference between bond and equity valuation is that equity value drivers are based on expectations, rather than defined by contracts.

Figure 1: The Basic Valuation Recipe – Same for Bonds and Stocks and Every AssetSource: New Constructs, LLC

We can extend the framework to demonstrate more detailed financial analysis. Figure 2 shows how business cash flows can be broken down into more intuitive financial terms like Revenue Growth and Return on Invested Capital (ROIC).

Figure 2: The Key Ingredients of the Valuation RecipeSource: New Constructs, LLC

**Using Intuitive Terms**

We can replace the cash flow variable and focus on the three variables with which investors are most familiar. We can use these three terms to quantify the specific financial performance required to justify stock prices for all companies:

- Revenue Growth (CAGR)
- Economic Earnings Margin (ROIC minus WACC)
- Growth Appreciation Period

Figure 3: The Valuation Recipe – Key Value DriversSource: New Constructs, LLC

New Constructs’ discounted cash flow model calculates the value attributable to stock prices based on the forecasted financial performance entered into the model.

We do not believe that we can forecast the future performance of a company into the future with any special accuracy.

Our model focuses on quantifying the market’s expectations for future cash flows. In turn, we leverage our model to reverse engineer the market’s expectations for the future financial performance of a company out of the stock price. This insight enables investors to calibrate their valuation assessment around the market’s expectations. The burden of predicting the specific performance of the core value drivers shifts to the market.

Investors only need to determine whether they feel market expectations are too high, too low, or about right.

**Terminal Value Assumptions**

The key difference between our DCF and others is that we calculate the value attributable to equity shareholders over multiple (100) different time periods. In addition, our yearly calculations represent different Growth Appreciation Periods (GAPS) because they are based on a Terminal Value that assumes the company generates no future incremental profits. To be specific, our Terminal Value for each annual calculation is a perpetuity calculation that assumes no future growth after each GAP. The formula is NOPAT_{t+1} divided by WACC. Using a Terminal Value that assumes no future profit growth enables our DCF model to calculate the specific value of companies implied by each Growth Appreciation Period.

See Figure 4 for a graphic representation of how our model’s dynamic discounted cash flow analysis calculates the implied value of a stock for multiple Growth Appreciation Periods. This chart shows how the value of the company analyzed in this example rises as its Growth Appreciation Period increases. The ‘Market Implied GAP’ equals the Market-Implied Growth Appreciation Period implied by the current market price.

Our model calculates the ‘*Market Implied* GAP’ by matching the current stock price with the year that the DCF model that produces the current stock price. For example, the ‘Market Implied GAP’ for the company in Figure 4 is 16 years. Our model can also calculate the GAP implied for target prices as well as any other stock prices no matter how great or small they may be.

Figure 4: Results of the Dynamic Discounted Cash Flow Calculations: Company Models calculate the GAP implied by the current stock priceSource: New Constructs, LLC

Figure 5 shows the summary info on the Decision Page in every one of our 3000+ models.

Figure 5: Decision Page provide summary of the discounted Cash Flow analysisSource: New Constructs, LLC

Figure 6 below, presents a copy of the DCF model used to generate the values in Figures 4 and 5.

Figure 6 also shows how our DCF model calculates values for multiple forecast horizons or Growth Appreciation Periods. These values provide the data needed to generate a chart like the one above and like the valuation matrix as presented on the Company Model Decision Page. Note the highlighted sections in Figure 6 and how they jibe exactly with the Revenue CAGRs, Economic Earnings Margin, and GAPs presented in Figures 4 and 5.

Figure 6: Sample Dynamic Discounted Cash Flow Model (click image to enlarge)

Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running