What Is A Discounted Cash Flow Model?

Discounted Cash Flow (DCF) is the most widely-accepted method to calculate the fair value of a company. The premise here is that the fair value of a company is the total value of its incoming cash (cash flow), subtracting its expenses, and then discount it to today's value. There are many variations of DCF that can be used depending on the particular company being applied to. For Ford (F), we are going to use the 2-Stage Discounted Cash Flow Model, generally suitable for companies that do not necessarily grow at constant rate over time. Other DCF models such as Dividend Discount Model, Excess Returns Model, and Adjusted-Funds-From-Operations Model are all inappropriate for Ford.   

The 2-Stage DCF, as the name suggests, takes into account 2 stages of growth: high-growth and stable-growth. The first stage is the high-growth period, calculated using estimates over the next ten years of levered free cash flow to equity, which is either sourced from analyst or estimated using extrapolated historical annual growth rate. The end stage is the stable-growth period, in which the company reaches terminal growth. A terminal value is calculated using the Gordon Growth formula, with an assumption that the company will continue to grow its earnings at the 10-year Treasury Yield, forever. Since a DCF is all about the idea that a dollar in the future is less valuable than a dollar today, we will need to discount the value of these future cash flows to their estimated value in today's dollars. To obtain a fair value share price, we divide the calculated present value by the number of available shares, giving a fair value per share.

Let's work through the calculations.

Examining The First 10-Year Fast-Growth Period

First we need to estimate future free cash flows, either from analysts' estimates or try to estimate ourselves based on assumed growth rates that decline in the later years. In the table below, we provide the estimated FCF for each year. Note that analysts' estimates are only available until 2025, after which we assume a very aggressively declining rate of free cash flow growth. 

Then we try to discount those future FCF to 2022's value using a discount rate, calculated as following:

• Discount rate = Cost of equity = Risk Free Rate + (Beta * Equity Risk Premium) = 2% + (1.08 * 8.64%) = 11.33%

  • Risk Free Rate is the rate of return that investors expect to receive in a risk-free asset. We use 2% from the US 10-Year Treasury Yield, which is what investors currently (or in average) get by buying the 10-Year US Government-Issued Bond, generally considered a risk-free asset.

  • Beta is used as a measure of the volatility of an asset in relation to the overall stock market. The overall market has a beta of 1. On CNBC.com, Ford Motors (F) stock has a beta of 1.08, which means it is slightly volatile than the stock market.

  • Equity risk premium for a stock refers to an excess return that investors expect to get compared to the rate of return on a risk-free asset (say the yield on a government-issued bond). This excess return compensates investors for taking on the higher risk of investing on an individual stock. There is no right or wrong here, but we can begin with the capital asset pricing model in which:

    • • equity risk premium = beta of asset * (expected overall stock market return - rate of risk-free asset)

      • For Ford, equity risk premium = 1.08 * ( 10% - 2%) = 8.64%. We're using 10% as the annualized return on the S&P 500 with data going back to the 1930s, and 2% as the yield on the US 10-Year Treasury which is essentially risk-free.  

After determining a discount rate, we calculate today's value of the free cash flow that will be generated each year in the future. The formula is as following:

• Present Value of A Future Year's FCF = Estimated FCF For That Year / (1 + discount rate) ^ number of years being discounted

  • Ford is estimated to generate $6.0 billion FCF in 2022. Since we are in 2022, the denominator has an exponent of 0, making the whole denominator equal 1, and therefore the present value of 2022's FCF is $6.0 billion. This should make sense, because this year's value of this year's FCF should just be this year's FCF.

  • Ford is estimated to generate $6.02 billion FCF in 2023 (although we think this number should be closer to 8.0). The denominator becomes (1 + discount rate of 11.33%)^(2023-2022). Therefore, discounting to 2022, Ford's FCF in 2023 is worth $5.4 billion.

After calculating today's worth of each future year' FCF, we can sum all 10 of those numbers up:

Present Value of 10-Year Cash Flow (PVCF) = PV of 2022 + PV of 2023 + ... PV of 2032 = $67.5 billion.

Examining The Terminal Stable-Growth Period

After calculating the present value of future cash flows in the initial 10-year fast growth period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first high growth period. For this, a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case, we use the 5-year average of the 10-Year Treasury Yield which is 2%. In the same way as with the 10-year high growth period, we discount future cash flows to today's value, using a discount rate or cost of equity of 9.05%. Terminal Value is calculated as follows:

Terminal Value (TV) = FCF 2032 x (1 + growth rate) / (discount rate - growth rate) = $12.3 Billion x (1 + 2.0%) / (11.33% - 2.0%) = $134.47 billion

Similarly, we need to discount the estimated Terminal Value to what it is worth in 2022:

Present Value of Terminal Value (PVTV) = TV / (1 + discount rate)^10 = $134.47 Billion / (1 + 11.33%)^10 = $45.97 Billion 

Total Equity Value At Present

We have calculated the present values of 2 stages, the initial high-growth stage and the terminal stage. We now can determine the total equity value, which is the sum of the present values of the 2 stages.

Total Equity Value = Present Value of 10-Year Cash Flow + Present Value of Terminal Value = $67.5 Billion + $45.97 Billion = $113.48 Billion 

The last step is to divide the equity value by the number of shares outstanding:

Fair Stock Price = Total Equity Value / Number of Shares Outstanding = $113.48 Billion / 4.00 Billion Shares = $28.37/Share

(An Excel file containing these calculations can be accessed here)

Summary Of Results 

Using the two-stage Discounted Cash Flow (DCF) Model, we have calculated the 2022 fair value of Ford (F) stock to be $28.37/share for the cash that the company is estimated to earn in the future. Here are the key assumptions, which changes will significantly affect the fair value:

•  a fast-growth 10-year period, by the end of which Ford would have doubled its cash flow generation (from $6.0 billion in 2022 to ~$12 billion in 2032).

• a terminal period in which Ford grows its cash flow generation at 2%, the same as the current yield of the US 10-Year Treasury (less than 2019's US real GDP growth of 2.3%). 

• a risk-free rate of 2%, equivalent to the long-term forecasted yield of the 10-year US Treasury.

• lastly, keep in mind that this is the fair value that you want to pay today, in 2022. Comes 2023, you will have to make different calculations. 

The bottom line, we have a price target of $28.37/share for Ford (F) stock in 2022 based on our analysis using the two-stage DCF. This price target would imply a 14 Price-to-Earnings multiple for Ford's estimated Earnings per Share of 2.03$ in 2022. On 2023's estimated EPS of $2.28, our price target of $28.37 equals a 12.44 P/E multiple. We believe this is a fair valuation multiple for a company that is growing, compared to the S&P 500's average P/E multiple of 20.