What's priced in?

How the math works

This is a simplified reverse DCF. A DCF, or discounted cash flow, values a company by adding up all the cash it should make in the future. A reverse DCF starts from the price instead and works out what the future has to look like. Here's each step, using the example numbers:

1. The price you'd need. Grow today's price at the return you want. At 10% a year for 10 years, a $40 stock has to reach about $103.75.
2. The company value you'd need. Multiply that price by the number of shares there will be by then. If the share count grows 2% a year, there are about 22% more shares in 10 years, so the whole company has to be worth that much more. That's the market cap needed.
3. The business value. Take out the company's net cash (cash minus debt), which I assume stays the same. What's left is the enterprise value needed, which basically just means what the business itself has to be worth.
4. The cash it has to make. Divide by the price-to-free-cash-flow multiple at the end. That's the free cash flow the business needs in the final year: the cash left over after running the business and paying for buildings and equipment.
5. The revenue it has to make. Divide that by the free cash flow margin. That's the revenue it needs in the final year.
6. The growth rate. Compare that with revenue today. The yearly growth rate that gets from here to there is the answer.

In the example, that's about $16.7 billion of revenue in year 10, up from $2 billion today, or about 23.7% a year. Whether that's easy or crazy depends on the company, which is why it also shows how fast revenue grew last year and over the last 3 years.

What this leaves out

The cash along the way. A real business makes (or burns) cash every year between now and the final year, and some of it gets paid out as dividends. This ignores all of that and only looks at the final year, so for a profitable company the answer is a bit demanding.

Every input is a guess: the margin, the multiple, the share count, even the return you want. Change the multiple from 25 to 15 and watch the answer jump. The small table in the result shows a few.

Banks, lenders and insurers don't fit this math, because their cash flow includes the loans and claims they pay out. Companies with little or no revenue don't either, since there's no growth rate to solve for.

And it's not a price target, or a reason to buy or sell anything. It turns a price into a story about the business, so you can check that story against what the company is actually doing.

Where the numbers come from

When you pick a stock, the numbers come from the company's own SEC filings (its 10-K and 10-Q): revenue and free cash flow over the last 12 months it has reported, cash and short-term investments, debt, the latest share count, and its revenue growth. You can change any of them. Foreign companies that report in another currency, or whose U.S. shares are ADSs that don't match the share count one for one, have to be entered by hand.

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