Recently I was asked how I arrived at my ‘annual return rate if price reaches FVDCF price’ that I quoted in my stock articles on Seeking Alpha.
Let’s start with the Fair Value Discounted Cash Flow (FVDCF) part of this statement:
This part of the equation is derived from a Discounted Cash Flow Model using owner earnings plus estimated growth rate, discounted by a desired and realistic return rate over a 10 year period.
The sum of these values are then added to the firm’s Equity and divided by shares outstanding to come up with an estimated fair price after expected growth.
Here is an example using Microsoft (MSFT) that projects a value of $41.46
The annual return rate portion of the statement:
Next, I take the current price and calculate the Combined Annual Growth Rate (CAGR) over a ten-year period to reach the FVDCF price calculated above.
In this case the CAGR required to reach the estimated price in a ten-year period would be approximately 3% (2.97%).
If I were to calculate Total Stock Return with dividends, assuming they stayed at the current level, the CAGR would be around 5%.
Why do I do this?
First, I aspire to look at investments of a long time period. I have determined that 10 years is my threshold for “long”.
I look at growth and price history, along with future prospects to evaluate if it is reasonable for the security in question to reach the estimated price level.
Secondly, I take that CAGR number that I have calculated and compare it to bonds and other types of investments I could have over the same time period.
Would I get a better return with less exposure to risk elsewhere?
That is the question I try to answer. If the answer is “no” and I have a high level of conviction with my valuation, then I have possibly found my next investment…