Nearly all fundamentals-driven professional investors use valuation tools to identify and decide on their investment decisions. The discounted cash flow (DCF) is one of the most important methods to assess the value of a stock or any investment. It’s a critical investment skill that you can use for your career and portfolio. This post will walk you through the DCF with Nvidia as an example.
In this post, we’ll cover:
- The DCF Concept
- Applying the DCF to a Bond
- The DCF for a Business
- Estimating the Discount Rate
- Calculating Terminal Value
- Applying DCF Valuation to Nvidia
Introduction to the DCF
Warren Buffet said that all valuation formulas can be traced to an ancient proverb by Aesop:
“A bird in the hand is worth two in the bush.”
The essence of a DCF is determining what you have now (the bird in the hand) versus what you could have in the future (the bird in the bush).
Then, an interest rate is used to compare the future versus present value.
The DCF model involves three main steps:
- Estimating the cash a business can generate
- Projecting the growth rate of these cash flows
- Applying a discount rate to determine the present value
Applying the DCF to a Bond
To see how the DCF works, consider the simplest cash-producing instrument—a bond.
When you purchase a bond from the U.S. government, you exchange cash today for a guarantee of interest payments and the money returned in the future.
Take a two-year U.S. government bond with a 0.875% coupon.
For each $1,000, you will receive these payments in the future:
- End of year 1: $8.75
- End of year 2: $8.75 + $1,000
The interest rate determines the value of that cash today because money has a time value. Money today is typically worth more than in the future.
If grocery prices rise 5-6% in the next two years—inflation—then the value of the money has gone down by 5-6%. The interest rate discounts the value of future money to reflect risks like inflation, among others.
The current 2-year interest rate, per the treasury bond market, is 3.6%. Let’s discount the cash from the bond payments by 3.6% each year.
Present value of cash flows = 8.75 / (1.036)1 + 8.75 / (1.036)2 + 1000 / (1.036)2
= $948.31
The value of a $1,000 bond is $948.31, or a ratio of 94.83 per 100.
When we look at the bond’s price today, it’s currently trading at 94.80.
That’s the DCF value!
The DCF for a Business
Now, let’s apply the DCF valuation to a business—such as Nvidia.
We replace the interest payments with the business’s cash flows, and then the value of the money returned at the end with the terminal value of the business (we’ll explain shortly).
- Estimate Cash Flows
First, we estimate Nvidia’s cash flows by adjusting the accounting to reflect how much cash the business generates after any investments and use of cash:
Fiscal 2024 estimates:
Sales of $127B
-Cost of sales of $33B
-Operating expense of $15B
(ex-depreciation & amortization, which is a non-cash expense)
=EBITDA of $79B
(Earnings before interest, taxes, depreciation and amortization)
EBITDA is a measure of Nvidia’s cash profits each year.
Then, we remove cash used for investments, working capital, interest, and taxes:
EBITDA of $79B
-Capital expenditures of $2B (investments into the business)
-Working capital use of $5B (capital for inventory, receivables, etc)
-Interest of $0.3B
-Taxes of $13B
=Free cash flow of $58B
This estimates the actual cash the business generates in 2024. It’s called “free” cash flow because this represents cash that the business can use for things like investments or to return to shareholders with dividends or share repurchases.
- Forecasting Growth
When projecting future cash flows, one key difference with businesses is they can grow their cash flows, unlike bonds, where the cash flows are fixed. Nvidia can use its cash for additional investments or research to sell to new markets, which will grow its future free cash flows.
So, the next step is to estimate the growth of the business:
2023-2033 Forecast (all compound annual growth rates or CAGRs):
Revenue growth of 24%
Operating margins to expand to 64%
Operating income growth of 26%
Invested capital growth of 16%
Free cash flow growth of 27%
By the way, these are very optimistic estimates.
It assumes Nvidia will grow its data center business at a 26% rate each year from 2023-2033 (slowing to a 15% rate in a few years) and can keep its profit margins stable. The forecast implies that most data centers will convert to GPUs for AI needs, and Nvidia will be the dominant supplier of these chips at a premium price.
This works out to about $800B in total free cash flows for that period.
- Discounting Cash Flows
Now that we have Nvidia’s free cash flows each year, we discount them like interest payments on a bond. However, instead of using an interest rate as a discount rate, we use the company’s cost of capital to discount future cash based on the company’s investment risk.
Value of cash flows = FCF₁ / (Cost of Capital)₁ + FCF₂(1+ Growth)/(Cost of Capital)₂…
Here’s why:
Estimating the Discount Rate
Every business raises money from investors, either as equity from selling company shares, or as debt from selling bonds (effectively loans) to investors. For analytical purposes, the money from profits is considered equity because it belongs to shareholders.
The money from investors has a cost of capital, which reflects the minimum return that equity and debt investors require to compensate them for the risks.
Here’s how we estimate the cost:
Cost of equity: We start with the risk-free rate (usually a 10-year U.S. government bond rate), then add a risk premium for equity, which is the additional return stocks historically provide investor above the risk-free rate.
We then adjust the equity risk premium by a beta factor to reflect the company-specific risk. Beta measures the company’s stock volatility relative to the market. The more volatile the stock is, the higher the beta and implied risk, which raises the risk premium.
Here’s Nvidia’s estimated cost of equity:
Risk-free rate of 3.7%
Risk premium of 4.55% X 1.6 beta for Nvidia
=Cost of equity of 11.5%
Cost of Debt: We use the interest rate on the company’s bond and adjust it for tax savings. Interest payments are paid before taxes, so they lower the company’s taxable income and tax payments. We adjust the cost of debt lower to reflect that tax benefit.
Here’s Nvidia’s estimated cost of debt:
Interest rate on debt of 3.5%
X (1-17% tax) adjustment
=Cost of debt of 2.9%
Then, we apply a weighted average of the company’s cost of debt and equity. We take the total value of the equity, the market capitalization or total market value of the company’s shares, and the total value of the debt, to work out the weights of each.
Nvidia’s average cost of capital:
0.3% Debt Weight X Cost of Debt of 2.9%
99.7% Equity Weight X Cost of Equity of 11.5%
=Nvidia cost of capital of 11.4%
Using this cost of capital, we can now discount Nvdia’s expected cash flows:
Value of Cash Flows = $58B / (1.14)1 + $79B / (1.14)2….. for the next ten years.
=$800B in present value of cash flows
Calculating Terminal Value
The final step is estimating the terminal value, which is the value of the company at the end of the forecast period. The assumption is that the company has reached the limits of its growth and is now growing at a slower, steady-state, usually in line with the economy.
We then discount the cash flows as if the company grows at this slower rate forever:
Terminal Value = FCF₁(1+ Growth) / (Cost of Capital)₁ + FCF₂(1+ Growth)/(Cost of Capital)₂…
If we assume this series goes on forever, the calculation simplifies to:
Terminal Value =FCF₁(1+ Growth) / (Cost of Capital – Growth)
This assumes the company’s growth rate will eventually fall below the discount rate because otherwise, the value of future cash flows would be infinite. The growth rate has to also fall in line with the economy’s growth, or the company’s size will also be infinite relative to the economy.
So, the long-term growth rate for U.S. companies is typically assumed to be 2-3%, which reflects the historic growth rate of U.S. GDP and its population.
Assuming Nvidia reaches $260B by year 10, here’s the estimated terminal value:
Terminal Value = $260B (1+ 3% long-term growth) / (11.4% cost of capital – 3% long-term growth)
=$3.2T trillion in terminal value (discounted to $1.2T in present value).
Bringing it all together:
The total value of Nvidia’s cash flows can be summarized as follows:
Total Value = Present Value of Free Cash Flows + Present Value of Terminal Value
Nvidia’s DCF valuation:
Present value of future cash flows: $800B for the next ten years
+Present value of terminal value: $1.2T
=$1.99T in estimated enterprise value
The enterprise value reflects both the value of equity and debt combined. To estimate the company’s equity value, we remove its current debt balance and add back any cash (assuming cash will be used to pay off debt).
Nvidia’s Equity Valuation:
Enterprise value: $1.99T
(-Debt of $8B)
(+Cash of $33B)
+Net Cash of $25B
=Equity Value of $2T
=$80 Share (25m shares)
Assuming an 11.5% cost of capital, Nvidia’s shares will appreciate to about $90 / share for the next year. When we compare this to Nvidia’s current price of $116 / share, it indicates Nvidia’s stock price has a premium that reflects strong growth expectations for the company.
We can also start to understand the expectations in Nvidia’s stock price.
For example,
If we assume stronger free cash flow growth of 31% CAGR through to 2033, Nvidia’s next year DCF valuation rises to $115 / share.
With a long-term growth rate of 4%, the value then rises to $126 / share.
The company’s shares are not undervalued, but they aren’t crazily valued, depending on how you expect Nvidia’s growth to play out over the next few years. We’ll see!
Conclusion:
The DCF helps you translate the business metrics into real stock values. It’s a rigorous tool to help you understand if a company’s stock is undervalued or overpriced using your estimated assumptions and understanding market expectations. By understanding the concept of the DCF, you deepen your knowledge of investing fundamentals and build your practical valuation skills.
