Reverse DCF

In simple terms

A normal DCF asks: given my forecasts, what is the business worth? The trouble is that forecasts are uncertain, and it is easy to tweak them until the answer looks right.

A reverse DCF runs the model the other way. It takes the current share price as given and asks: what would have to happen for this price to be fair? Usually it solves for the growth rate in free cash flow that the price implies, holding the discount rate and other assumptions fixed.

This changes a hard question, predicting the future precisely, into an easier one: judging whether what the market already assumes is plausible.

How it works

1. Start from the market value. Market capitalisation plus net debt gives enterprise value.
2. Fix the other assumptions: the discount rate, the forecast period, the long-run growth rate after it, and the starting free cash flow.
3. Find the growth rate in the forecast period that makes the DCF value equal the market value. A spreadsheet's goal-seek function does this, or you can try a few rates.
4. Compare the implied growth with what is realistic.

Judging implied expectations

Compare the implied growth with:

• The company's own history, measured over a full cycle, as the growth lesson explains.
• Its industry's growth. A company can grow faster than its industry only by taking share, which competitors resist.
• Its returns on capital. Growth needs reinvestment; the incremental returns lesson shows how much. Fast growth with little investment requires very high returns.
• What similar companies have achieved. Very few companies sustain growth above 20% a year for a decade.
• The size of the market. Implied revenue in ten years should be a plausible share of the total market.

If the implied expectations look easy to beat, the share may be undervalued. If they require something exceptional, the share is priced for perfection, and even good news may disappoint.

Implied margins and returns

Growth is not the only thing you can solve for. You can hold growth fixed and solve for the operating margin the price implies, or the return on capital. For example, a price might imply that a company's margin doubles from today's level. Asking whether competitors would allow that is often more revealing than arguing about growth rates.

Using reverse DCF with other tools

Reverse DCF does not replace a normal DCF or valuation multiples. It complements them.

• A normal DCF tells you what you think the business is worth.
• Multiples tell you how it is priced compared with others.
• A reverse DCF tells you what the market is assuming.

When all three point the same way, you can be more confident. When they disagree, the disagreement usually points to the assumption that matters most.

Why it matters

Most investment mistakes involving popular shares come from paying prices that assume extraordinary results for many years. A reverse DCF makes those assumptions visible in a single number you can test against history and common sense. It is also a guard against your own optimism: instead of building a forecast to justify a price, you check whether the price is justified by what is realistic.

Limitations

The implied growth rate depends on the discount rate, the forecast period and the terminal assumptions you fix. A higher discount rate raises the implied growth; a higher terminal growth rate lowers it. Test the result with a few combinations, as the sensitivity lesson shows. Like any DCF, it is not suitable in this form for banks and insurers.

Common mistakes

• Treating the implied growth rate as a forecast. It is the market's assumption, which you must judge.
• Fixing an unrealistically high terminal growth rate, which makes any price look reasonable.
• Ignoring reinvestment needs when judging whether implied growth is achievable.
• Using one discount rate only.

Try it yourself

1. Choose a listed company with a high P/E.
2. Using its latest free cash flow, net debt, share count and price, set up a five-year DCF with a discount rate and long-run growth you can justify.
3. Find the five-year growth rate that makes the DCF value equal the market price.
4. Compare that rate with the company's ten-year history and its industry's growth, and write down whether the market's expectations look easy, reasonable or demanding.