Stock Investing Skills

Step-by-Step Discounted Cash Flow (DCF) Model for Alphabet (GOOG/GOOGL)




The DCF model is used to estimate the intrinsic value of Alphabet by forecasting its future free cash flows (FCFs) and discounting them back to their present value.

1. Gather Key Inputs for the Model

A. Free Cash Flow (FCF) Data

  • Alphabet's Free Cash Flow (FY 2022): $60 billion.
  • Assume FCF growth of 10% annually for the next 5 years.

B. Discount Rate (WACC)

  • Weighted Average Cost of Capital (WACC): 8% (based on Alphabet's risk profile).

C. Terminal Growth Rate

  • Growth rate after the forecast period: 3% (reasonable for a mature company).

2. Forecast Free Cash Flows for 5 Years

Using the formula for FCF growth:
[
{FCF}{t} = {FCF}{t-1} * (1 + g)
] Where:
- ( {FCF}_{t-1} ): Previous year's FCF.
- ( g ): Growth rate (10% or 0.10).

| Year | FCF Formula | Free Cash Flow ($B) |
|----------|---------------------------------|-------------------------|
| 1 | ( 60 * (1 + 0.10) ) | $66.0 |
| 2 | ( 66.0 * (1 + 0.10) ) | $72.6 |
| 3 | ( 72.6 * (1 + 0.10) ) | $79.9 |
| 4 | ( 79.9 * (1 + 0.10) ) | $87.9 |
| 5 | ( 87.9 * (1 + 0.10) ) | $96.7 |

3. Calculate Terminal Value (TV)

After Year 5, FCF grows perpetually at the terminal growth rate (g) using this formula:
[
{Terminal Value (TV)} = \frac{{FCF}{6}}{r - g}
]
Where: - ( {FCF}{6} = {FCF}_{5} * (1 + g) ). - ( r ): Discount rate (8% or 0.08).
- ( g ): Terminal growth rate (3% or 0.03).

Step-by-Step Calculation:

  1. ( {FCF}_{6} = 96.7 * (1 + 0.03) = 99.6 \, {billion} ).
  2. ( {TV} = \frac{99.6}{0.08 - 0.03} = \frac{99.6}{0.05} = 1,992 \, {billion} ).

4. Discount Future Cash Flows to Present Value

Use the Present Value (PV) formula for each year's cash flow:
[
{PV} = \frac{{FCF}}{(1 + r)^t}
] Where:
- ( t ): Year.
- ( r ): Discount rate (8% or 0.08).

| Year | FCF ($B) | Discount Factor (( (1 + r)^t )) | PV of FCF ($B) |
|----------|--------------|---------------------------------------|----------------------|
| 1 | 66.0 | ( (1 + 0.08)^1 = 1.08 ) | ( \frac{66.0}{1.08} = 61.1 ) |
| 2 | 72.6 | ( (1 + 0.08)^2 = 1.166 ) | ( \frac{72.6}{1.166} = 62.3 ) |
| 3 | 79.9 | ( (1 + 0.08)^3 = 1.26 ) | ( \frac{79.9}{1.26} = 63.5 ) |
| 4 | 87.9 | ( (1 + 0.08)^4 = 1.36 ) | ( \frac{87.9}{1.36} = 64.6 ) |
| 5 | 96.7 | ( (1 + 0.08)^5 = 1.47 ) | ( \frac{96.7}{1.47} = 65.8 ) |

Discount the Terminal Value:

[
{PV of TV} = \frac{{TV}}{(1 + r)^5} = \frac{1,992}{1.47} = 1,355 \, {billion}
]

5. Calculate Total Enterprise Value (EV)

Add up the discounted cash flows and terminal value:
[
{EV} = {Sum of PV of FCFs} + {PV of TV}
]

Step-by-Step Calculation:

  • ( {Sum of PV of FCFs} = 61.1 + 62.3 + 63.5 + 64.6 + 65.8 = 317.3 ).
  • ( {PV of TV} = 1,355 ).
  • Enterprise Value (EV):
    [
    {EV} = 317.3 + 1,355 = 1,672.3 \, {billion}
    ]

6. Adjust for Net Debt to Find Equity Value

Net Cash Position:

  • Alphabet has a net cash balance of $100 billion (cash minus debt).

Equity Value:

[
{Equity Value} = {EV} + {Net Cash}
] [
{Equity Value} = 1,672.3 + 100 = 1,772.3 \, {billion}
]

7. Calculate Intrinsic Value Per Share

Shares Outstanding:

  • Alphabet has approximately 13.2 billion shares outstanding (common + Class A/B/C).

Intrinsic Value Per Share:

[
{Intrinsic Value Per Share} = \frac{{Equity Value}} / {{Shares Outstanding}}
] [
{Intrinsic Value Per Share} = \frac{1,772.3}{13.2} \approx 134.2 ]

8. Interpret Results

  • Estimated Intrinsic Value: $134.2 per share.
  • Current Market Price: Compare the intrinsic value ($134.2) to Alphabet’s current stock price.
  • If the market price is below $134.2, the stock may be undervalued.
  • If the market price is above $134.2, the stock may be fairly valued or overvalued.

9. Sensitivity Analysis

DCF models rely on assumptions like growth rate, WACC, and terminal growth. Perform a sensitivity analysis to see how changes impact valuation.

| WACC (%) | Terminal Growth (%) | Intrinsic Value ($) |
|--------------|--------------------------|--------------------------|
| 7.0 | 3.0 | 150 |
| 8.0 | 3.0 | 134 |
| 8.0 | 2.5 | 128 |
| 9.0 | 3.0 | 120 |

Final Thoughts

The DCF model shows that Alphabet is slightly undervalued or fairly priced at ~$134 per share, assuming a WACC of 8% and 10% FCF growth. Adjust your assumptions for a more tailored valuation.

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