Reverse DCF: Another Way to Evaluate Stocks

Posted
5/29/2013 6:27:00 PM
By: GuruFocus
Referenced Stocks:AAPL

We have made further improvement to our DCF Calculator. Now you can evaluate the stock with Reverse DCF in one click.

With Reverse DCF what you get is the growth rate of free cash flow that company needs to have to justify its current stock price. The default input parameters are:

1. Earnings per share: The EPS from the past 12 months
2. Years of growth at the growth rate: 10
3. Terminal growth rate: 4%
4. Discount rate: 12%.

These parameters are the same as in DCF Calculation. All of them are adjustable and adjusting any of them will trigger re-calculation. The 10-year average growth rates of revenue, earnings, EBITDA, FCF and book value are provided for you to compare.

After you get the growth rate, compare it with the past growth rates and ask yourself if the growth rate is likely for this company. If the calculated growth rate is higher than the past growth rates, the stock price might be ahead of itself. If the growth rate is lower than the past growth rates, the stock might be undervalued.

Similar to DCF Calculator, Reverse DCF works well for the companies with predictable revenue and earnings growth .

Consider Apple ( AAPL ): The company has growth its revenue by 38% a year and earnings by 85% a year over the past 10 years. Assuming it will grow 20% a year over the next 10 years, the DCF Calculator thinks the stock is worth \$1,192 a share. Please see the screenshot below.

Of course, whether the company can continue to growth 20% a year is a big question. Now if we switch to Reverse DCF, it tells us that the current Apple stock price of \$443 a share suggests that the market thinks the company will only grow its earnings 4.85% a year over the next 10 years. See the screenshot below:

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Will Apple be able to grow at 4.85% a year over the next 10 years? This is the question one needs to answer when it comes to using the Reverse DCF Calculator.