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Serious investors should have the ability to estimate the fair value of assets they invest in.

Bill Ackman, for instance, emphasizes the importance of factors like discount rates and growth projections when assessing the company value.

A model that relies on these factors is the ‘Discounted Cash Flow’ model, which estimates a company’s intrinsic value by projecting and discounting future cash flows.

However, as you’ll see next, it’s not an exact science and depends heavily on the analyst’s assumptions and knowledge.

In this guide, we will break down the DCF model into clear steps using fundamental data obtained via the Financial Modeling Prep (FMP) API.

We will show you how to project future cash flows, discount them to their present value, and calculate the terminal value.

To help you apply these steps, we’ve prepared an end-to-end Google Colab notebook. This will allow you to implement the model yourself and adjust the key assumptions as needed.

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DCF model estimates the present value of a company by projecting future free cash flows and discounting them back to the present using a discount rate:

Here are FCFt are the future projected cash flows, r is the discount rate, TV is the terminal value. We’ll discuss each in detail.

The first step in the DCF model is to project the company’s future free cash flows.

These cash flows represent the amount of cash a company generates after accounting for capital expenditures:

To project FCF, start with the most recent FCF and apply a growth rate, g:

This growth rate is based on the company’s earnings projections, industry averages, or analyst estimates.

Cash flows are forecasted until a stable growth period is expected, often 5 to 10 years into the future.

The next step is to discount the future FCFs to their present value using a discount rate, usually derived from the ‘Weighted Average Cost of Capital’.

WACC reflects the company’s cost of equity and debt, adjusted for tax effects:

By discounting future cash flows, you determine what those future dollars are worth today.

Please note that calculting the cost of equity and the cost of debt involves its own process which we will discuss in the implementation below.

Next, estimate the terminal value, which accounts for all future cash flows beyond the forecast period. The terminal value represents the company’s value at the end of the projection period.

This can be calculated using the Gordon Growth Model. In this model, you need to assume a constant ‘perpetual’ growth rate that reflects long-term expectations.

One can set the perpetual growth rate, g, at 2% or 3% to align with long-term economic growth or inflation expectations.

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With the discounted FCFs and terminal value in hand, you can calculate the enterprise value of the company.

This is done by summing the present value of the projected FCFs and the discounted terminal value.

The enterprise value represents the total value of the company’s operations in today’s terms.

To move from enterprise value to equity value, subtract net debt. This adjustment accounts for the company’s financial obligations. The remaining value reflects what is available to equity investors.

Net debt is simply the company’s total debt minus its cash and cash equivalents.:

Next step is to isolate the value that belongs to shareholders:

Finally, divide the equity value by the number of shares outstanding to calculate the intrinsic value per share.

This value represents what each share of the company is worth based on the DCF model.

Comparing this intrinsic value to the current market price will help you determine whether the stock is undervalued or overvalued.

Let’s now set up the code for pulling in the financial data, and calculating everything needed for the DCF model.

We’ll build the DCF model programmatically to make the process more efficient and flexible when tweaking assumptions for different scenarios.

First, ensure these libraries are installed:

Then, we need to set up the variables required to pull data for the stock we are analyzing.

We’ll use NVIDIA (ticker: NVDA) as an example, but you can replace it with any other stock ticker.

The Financial Modeling Prep API give you access to a wide range of financial data, including but not limited to:

Next, we retrieve the company’s cash flow statement. Free Cash Flows are typically stated directly. If not, you can deduce them by deducing capital expenses from operating cash flows.

We’ll use the FMP API to pull in the cash flow data for the last four quarter. After pulling the data, we sum up the last four quarters to get the Trailing Twelve Months cash flow. This gives the latest full year’s worth of cash flow data:

Now, let’s grab the income statement data. This is where we get a clear picture of the company’s profitability —Interest Expense, Pretax Income, and Tax Provision.

We’ll focus these key figures for calculating Cost of Debt and the True Value of the Firm.

Similarly to Cash Flows, we sum up the last four quarters to get the TTM totals.

The balance sheet provides a snapshot of the company’s financial position — Assets, liabilities, and equity at a specific point in time.

For our purposes, we’re particularly interested in the company’s total debt, which we’ll use to calculate the cost of debt.

To calculate the cost of debt, we first need to determine the effective tax rate. The effective tax rate helps adjust the cost of debt in the WACC calculation.

This adjustment accounts for the fact that interest expenses are tax-deductible, which reduces the actual cost a company incurs on its debt.

To calculate the effective tax rate, we follow these steps:

1. Calculate the Total Income Tax Expense: Sum up the income tax expenses from the last four quarters.

2. Calculate the Total Income Before Tax: Sum up the income before tax figures from the last four quarters.

3. Determine the Effective Tax Rate: Divide the total income tax expense by the total income before tax.

The Cost of Debt is calculated by dividing the total interest expense by the total debt.

First, sum up the interest expenses from the last four quarters. This gives us the total interest the company has paid over the past year.

Next, we sum up the company’s total debt from the last four quarters to get an accurate view of its borrowings over the past year.

The pre-tax cost of debt is calculated by dividing the total interest expense by the total debt.

Finally, adjust the pre-tax cost of debt by the effective tax rate to get the after-tax cost of debt.

This adjustment reflects the tax benefits the company receives on its interest payments.

Note: If the Interest Expense is not directly stated in the financial statements, you can estimate it using other methods, such as reviewing company filings (10-Ks), using historical data, using market data (e.g., Moody’s, S&P, or Fitch and comparable bond yields) or referencing industry averages.

We calculate the cost of equity using the Capital Asset Pricing Model:

There are a number of parameters which need to be calculated. We do that below.

To calculate the Cost of Equity using CAPM, we need to determine three key components: Beta, the Risk-Free Rate, and the Market Risk Premium. These factors represent the expected return that equity investors require.

Beta measures the stock’s volatility relative to the market and captures one type of risk — market risk. We calculate Beta by analyzing historical price data for both the stock and a market index, such as the S&P 500.

The risk-free rate represents the return on an investment with zero risk. The risk-free rate is often derived from government bond yields, typically using the 10-year or 30-year Treasury yields.

The 10-year yield balances short- and long-term risks, while the 30-year yield offers a longer-term outlook for extended investments. We’ll use the 10-year treasury yield in this example and retrieve it from Yahoo Finance.

The Market Risk Premium is the difference between the expected return of the market (E(Rm)) and the risk-free rate. This premium compensates investors for taking on the higher risk of investing in the stock:

Where E(Rm) is the expected market return, calculated as:

Finally, we calculate the Cost of Equity using the CAPM:

The WACC formula represents the average rate a company is expected to pay its security holders to finance its assets.

It combines the cost of equity and the after-tax cost of debt, weighted by their proportions in the company’s capital structure. Here’s the formula we’ll use:

First, we fetch the current market price of the stock and the number of outstanding shares. These are necessary to calculate the company’s market capitalization, which forms the equity component in the WACC formula.

With the current market price and the number of outstanding shares, we can now calculate the market capitalization:

Finally, we calculate the WACC by determining the weights of equity and debt in the company’s capital structure, and applying the respective costs:

As you see, the cost of Capital for Nvidia is quite high! This means that investors demand a substantial return to compensate for the risks associated with holding the stock.

for Nvidia in particular, a high cost of equity is primarily driven by its high beta (high market volatility). This higher risk, along with the intense competition and high growth expectations in the semiconductor and AI markets, pushes investors to expect higher returns.

Estimating future growth potential is the key to projecting future cash flows. We’ll pull in estimates for EPS growth automatically.

We’ll get this data from Finviz, where analysts provide forecasts.

Specifically, we’ll grab the EPS growth estimate for next year and the average growth estimate for the next five years.

Alternatively, you may choose to specify your own growth estimates based on your research or other sources you trust.

The growth expectations are quite high for Nvidia. 40+% EPS Growth per year!

You should adjust this value according to your own research to determine if NVDA is currently over value or under valued.

We’ll project the company’s Free Cash Flows over the next 10 years to estimate its future value using the EPS growth rates obtained earlier.

For the first five years, we use the initial EPS growth rate:

From year 6 onward, we assume a slower growth rate, calculated as:

The terminal value represents the value of all future free cash flows beyond the projection period.

We calculate it using the last projected FCF and a terminal growth rate, which reflects the expected long-term growth of the company (i.e. the rate at which the company will grow for ever).

The terminal growth rate should be conservative, often slightly above the long-term inflation rate or aligned with the broader economy’s growth expectations (i.e. GPD growth).

To determine the enterprise value of the company, we need to discount the projected Free Cash Flows and the terminal value back to their present value using the discount rate we got using the WACC formula.

For each year in our projection, we discount the projected FCF to its present value. The formula to calculate the discounted FCF is:

Similarly, we discount the terminal value to its present value using:

Finally, the enterprise value is the sum of all discounted FCFs and the discounted terminal value:

To determine the intrinsic value per share, which reflects what is left for equity investors after accounting for debt, we follow these steps:

1. Calculate Net Debt: This represents the total debt of the company minus its cash and cash equivalents.

2. Calculate Equity Value: Subtract the net debt from the enterprise value to find the equity value.

3. Calculate Intrinsic Value Per Share: Divide the equity value by the number of shares outstanding.

The current stock price $119, so as you see we are not too far away. Reaching this intrinsic value requires assuming a high growth rate.

It’s up to you to decide whether NVIDIA is currently overvalued or undervalued based on these growth projections.

The margin of safety quantifies how much a stock is potentially under or overvalued. It is calculated by comparing the intrinsic value per share, which we derived from our DCF analysis, with the current market price.

A positive margin of safety suggests that the stock price is below its intrinsic value, providing a buffer against potential errors in our assumptions or unexpected market conditions.

We can generate a matrix of possible intrinsic values under different assumptions of WACC and growth rates.

This approach helps visualize how sensitivity the intrinsic value is to changes in these two key assumptions.

From the FMP API, we can automate all all of the process above by retrieving the fair value of a given stock automatically.

However, this comes at a cost of flexibility if you wanted to input your own assumptions as we did above.

Let’s compare the intrinsic value calculated from our discounted cash flow analysis with values retrieved directly and automatically from the FMP API using both standard and levered DCF models.

This comparison helps validate our findings and provides an additional layer of analysis.

Second, please note that the FMP API offers a lot of the metrics that we computed here manually such as:

DCF relies heavily on projections. Predicting future cash flows and growth rates isn’t an exact science, and even small changes in assumptions will significantly alter the outcome. This sensitivity means that the DCF model can easily lead to inaccurate valuations, especially when looking far into the future.

Another issue with the DCF model is the difficulty in pinpointing the right discount rate. WACC depends on various factors like market conditions and the company’s capital structure. Both of these can change over time. The DCF model also assumes a company will grow at a constant rate indefinitely, which is rarely the case in reality.

Additionally, the DCF model doesn’t directly account for external factors like market conditions or competition. It focuses solely on a company’s intrinsic value based on its financials, potentially overlooking significant influences on the stock price.

It’s always smart to explore complementary methods to calculate the fair value of stocks and get a more complete picture of a company’s worth. One useful approach is the ‘Comparable Companies Analysis’.

This method involves comparing a company to its peers by looking at multiples like Price-to-Earnings (P/E) or Enterprise Value-to-EBITDA. Financial Modeling prep makes this simple this simple by accessing its key financial metrics API.

Another approach is the ‘Precedent Transactions Analysis’. This method examines the prices paid for similar companies in past mergers or acquisitions. It offers insight into what buyers have been willing to pay in actual transactions, making it particularly useful for valuing private companies or during times of market volatility.

The ‘Dividend Discount Model’ (DDM) is another method, especially for companies with a history of stable dividend payments. This model calculates the fair value of a stock based on the present value of expected future dividends. This is particularly relevant for mature companies where dividends play a significant role in returns.

Lastly, the ‘Sum-of-the-Parts’ (SOTP) analysis can be beneficial for conglomerates or companies with various business units. By valuing each division separately and then summing these values, investors can estimate the overall company’s worth. This method ensures that each business unit’s value is properly recognized.

Calculating the fair value of stocks is essential for serious investors who are committed to thorough due diligence.

The DCF model offers a straightforward approach to estimate this value, especially when data is readily available to project future cash flows and assess the cost of capital.

However, the DCF model has its limitations, as it depends on assumptions. To gain a more comprehensive understanding, it’s advisable to use additional and complementary valuation methods.