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Welcome to the stockTargetPrice wiki!
To calculate the stock target price using JavaScript, follow my guidance and download my code to get a fully functional app that allows you to calculate the stock target price in seconds. However, if you want to understand the principles behind the DCF model, read the article below. This article is written using ChatGPT.
How to Calculate a Stock’s Target Price Using the Discounted Cash Flow (DCF) Model
Investors seeking to determine the intrinsic value of a stock often turn to the Discounted Cash Flow (DCF) model. This method estimates the present value of a company based on projections of future cash flows, providing a target price to help gauge whether a stock is overvalued or undervalued. Here’s a comprehensive guide to calculating a stock’s target price using the DCF model.
The DCF model calculates the present value of expected future cash flows generated by a company. It discounts these cash flows back to their present value using the company's weighted average cost of capital (WACC). The sum of these present values gives the intrinsic value of the company, which can then be compared to its current market value to determine if it is a good investment.
Free Cash Flow represents the cash a company generates after accounting for cash outflows to support operations and maintain capital assets. To forecast FCF:
- Historical Analysis: Analyze the company's historical FCF to identify trends.
- Growth Rates: Project future growth rates based on historical trends, management's guidance, and industry conditions.
- Forecast Period: Typically, forecast FCF for 5 to 10 years.
For example, if a company has the following historical FCF:
- 2020: $50 million
- 2021: $55 million
- 2022: $60 million
You might project a growth rate of 10% for the next five years.
The terminal value represents the present value of all future cash flows beyond the forecast period, assuming a perpetual growth rate. It is calculated using the Gordon Growth Model:
Terminal Value = FCF in final forecast year *(1 + g)/(r - g)
Where: g = Perpetual growth rate (e.g., long-term GDP growth rate or inflation rate, typically 2-3%) r = Discount rate (WACC)
The discount rate is the WACC, reflecting the cost of the company’s capital (equity and debt). It accounts for the risk associated with the company’s cash flows.
WACC = E/V * Re + D/V * Rd * (1 - T)
Where:
- ( E ) = Market value of equity
- ( D ) = Market value of debt
- ( V ) = Total value (E + D)
- ( Re ) = Cost of equity
- ( Rd ) = Cost of debt
- ( T ) = Corporate tax rate
The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM):
Re = Rf + beta * (Rm - Rf)
Where:
- ( Rf ) = Risk-free rate (e.g., yield on 10-year Treasury bonds)
- ( \beta ) = Beta (volatility measure relative to the market)
- ( Rm ) = Expected market return
Discount the projected FCF and terminal value back to the present value using the WACC:
PV of FCF = FCF^t/(1 + r)^t
Where ( t ) is the year and ( r ) is the discount rate.
PV of Terminal Value = Terminal Value/(1 + r)^n
Where ( n ) is the number of years in the forecast period.
Sum the present values of the projected FCF and the terminal value to get the total enterprise value (EV):
Enterprise Value = PV of FCF + PV of Terminal Value
Subtract net debt (total debt - cash) to find the equity value:
Equity Value = Enterprise Value} - Net Debt
Finally, divide the equity value by the number of shares outstanding to get the intrinsic value per share (target price):
Target Price = Equity Value/Shares Outstanding
Let’s apply this to a hypothetical company:
- Historical FCF: $100 million, $110 million, $121 million over the past three years.
- Growth Rate: 10% for the next five years.
- WACC: 8%
- Perpetual Growth Rate: 3%
- Net Debt: $200 million
- Shares Outstanding: 10 million
Forecasted FCF for the next 5 years:
- Year 1: $133.1 million
- Year 2: $146.4 million
- Year 3: $161 million
- Year 4: $177.1 million
- Year 5: $194.8 million
Terminal Value after 5 years: [ \text{Terminal Value} = \frac{194.8 \times 1.03}{0.08 - 0.03} = $4,020.64 \text{ million} ]
Present Value of FCF: [ \text{PV of FCF} = \sum \frac{{133.1}}{{(1 + 0.08)^1}} + \frac{{146.4}}{{(1 + 0.08)^2}} + \cdots = $627.8 \text{ million} ]
Present Value of Terminal Value: [ \text{PV of Terminal Value} = \frac{{4,020.64}}{{(1 + 0.08)^5}} = $2,751.5 \text{ million} ]
Enterprise Value: [ \text{Enterprise Value} = 627.8 + 2,751.5 = $3,379.3 \text{ million} ]
Equity Value: [ \text{Equity Value} = 3,379.3 - 200 = $3,179.3 \text{ million} ]
Target Price: [ \text{Target Price} = \frac{3,179.3}{10} = $317.93 ]
The intrinsic value or target price of the stock is $317.93 per share.
- Forecasting Accuracy: Future cash flows and growth rates are estimates and may not be accurate.
- Discount Rate: Small changes in WACC can significantly affect the intrinsic value.
- Perpetual Growth Rate: Choosing an unrealistic perpetual growth rate can lead to erroneous terminal values.
- Market Conditions: DCF is based on fundamental analysis and may not account for market sentiments or short-term fluctuations.
The DCF model is a powerful tool for estimating the intrinsic value of a stock. By carefully projecting future cash flows, selecting an appropriate discount rate, and calculating the terminal value, investors can derive a stock’s target price. This model helps in making informed investment decisions based on the fundamental value of a company, though it should be used in conjunction with other analyses to account for market dynamics and unforeseen factors.
This article provides a detailed walkthrough for calculating a stock's target price using the DCF model, suitable for investors looking to understand and apply this valuation method effectively.