This will sound weird, but whenever I’m building a DCF [discounted cash flow] model the song “Stairway to Heaven” involuntarily pops into my head. Creating a solid DCF involves working through a number of intermediate steps. If you build the foundation correctly, your reward at the end is DCF heaven: A price target that represents the intrinsic value of the stock.

There are many interpretations as to what the lyrics to “Stairway to Heaven” mean, but I’m almost certain that Page and Plant weren’t scrawling out a DCF when they came up with the song! Regardless, I believe the song has plenty to teach us about security analysis. Here are my seven steps to DCF heaven.

1.   All that Glitters is not Gold

“There’s a lady who’s sure, all that glitters is gold

And she’s buying a stairway to heaven”

When building a DCF it’s important to realize that small changes to your key assumptions will cause huge changes to your price target. Analysts often go wrong when they extrapolate aggressive revenue growth and margin expansion. The law of large numbers means that a company with $1bn of revenues growing at 10% is unlikely to be growing at the same pace when it’s a $3bn company. Terminal growth rate should be set at no greater than 2.5% (the reasoning being that no company can grow faster than US GDP indefinitely without becoming the economy itself). Another way of expressing this point is that Crap In = Crap Out (CICO).

2.   KISS

No, this isn’t a reference to another 1970s rock band. KISS = Keep it Simple, Stupid. One thing that always frustrated me about Wall Street analyst’s models was the number of tabs on the excel spreadsheet – often 20 or more. And the more detail they included, the less useful the DCF. While the analyst was obsessed about the tax rate applied to sales in Malaysia, they missed major flaws in their key assumptions. In other words, they could no longer see the woods for the trees.

3.   Show How you Derive Figures

“There’s a sign on the wall but she wants to be sure

‘Cause sometimes you know words have two meanings”

In a DCF there will always be a few key assumptions that everyone will be wondering how you derived. So it’s worth explaining these clearly at the outset. The key ones you should make sure to cover are the WACC (I prefer a simple methodology for deriving this) and revenue growth.

4.   Monitor Percentage Metrics as a Sense Check

Sometimes models end up going very, very wrong. Usually because assumptions that seem sensible in the context of one year, result in absurdities by year ten (see point 1). This is why it’s important to sense check each year’s forecast against percentage metrics, such as Operating Margin and ROIC. Then ask yourself – is it reasonable that margins are higher than at any point in the past? Is it reasonable that ROIC remains far above WACC by year ten. This might indeed be the case, but if it is then ensure that you take the time to justify why.

5.   Consider Capital Intensity

It’s important that capital intensity is properly accounted for in your DCF. A classic mistake is in assuming a high level of growth, but failing to consider the capital required to achieve that growth. PP&E (Property, Plant & Equipment) can be forecast as a percentage of revenues (since asset turns tend to remain fairly constant). Once you’ve modeled this line item, it’s possible to forecast depreciation and then Capex. Checking back on ROIC (see 4 above), will ensure you’re not getting carried away. The same concept also applies to Working Capital.

6.   Cross Check to Multiples

This ties again back to point 1: Your DCF model is only as good as your assumptions. Once you get to your price target it’s important to sense check against multiples to ensure you haven’t made any wild assumptions. Where you end up with a fantastically high multiple, then you need to go back through your numbers and double check what you’ve done.

7.   Keep it Live

“Yes there are two paths you can go by, but in the long run

There’s still time to change the road you’re on”

You should think of the DCF as a living piece of analysis. As events unfold, you will naturally want to update your numbers. Some assumptions will end up being either too aggressive or too conservative. There’s absolutely nothing wrong with changing your view as more evidence comes to light. And if that causes you to change your rating, then so be it:

“When the facts change, I change my mind. What do you do sir?”  John Maynard Keynes (the original “Rock Star” economist)

We have quite a few “Rock Star” analysts at StockViews, and we encourage them to supply a simple DCF, particularly when initiating on a stock. Any questions on building a DCF? Let us know in the comments section, or you can contact me here.

“And as we wind on down the road

Our shadows taller than our soul.

There walks a lady we all know

Who shines white light and wants to show

How everything still turns to gold.

And if you listen very hard

The tune will come to you at last.

When all are one and one is all

To be a rock and not to roll”