Editor's note: This article has been corrected. The original discounted cash flow model on Dell contained an error in determining the stock's implied value. Operating income was erroneously included in the calculation of unlevered free cash flow. As a result, other adjustments were required to arrive at a justifiable price. In this case, that meant changes to the forecasts for gross margin, capital spending and acquisitions. The new implied price is $13.60, compared with the initial per-share value of $13.61.
Dell (DELL) has been making headlines recently following reports it could be nearing a deal to go private for a price in the neighborhood of $13 to $14 a share. Based on Yahoo Finance’s analysis, that’s about the right price. Using a discounted cash flow projection, our model puts an implied value of $13.60 on the PC maker’s shares.
While Dell still has substantial revenue, currently above $60 billion a year, its stock has been sluggish for years and hasn't been above $20 since 2008. For many people, it's an afterthought, a relic of the dot-com boom. Despite the stock's 18% gain this past week to $12.84, it remains several points below its 52-week high of $18.36.
Still, if our model is right -- and a deal does happen -- there’s a bit more potential upside in Dell even after its recent bounce. This case also presents us with an opportunity to talk about something you can do at home with a little effort -- with Dell or any other company -- and that's build a financial model and be your own analyst. So while we'll explain important parts of our thinking on Dell specifically, we'll cover the discounted cash flow (DCF) modeling concept broadly. Numerous valuation models could be run, including comparing comparable companies and examining prior transactions, but for this exercise, we went with a DCF. It's far from perfect, since this method relies heavily on a host of assumptions, and we're going out five years. That said, any investor can do it by setting aside time to try.
[Dell projections: Study our full model here.]
In Dell's case, we started out relying on the consensus analyst view that sales are on a downward path. Using FactSet estimates for the next three years, we've set Dell at a top line of $54.6 billion in 2015. For product revenue, we're anticipating a fall amid the tremendous competition in the sector. However, services revenue can grow, but it won't be enough to keep total revenue from deteriorating to $53.5 billion in 2017.
We postulated in our model that selling, general and administrative expenses will remain around $7.5 billion each year, with minor decreases annually. Research, development and engineering outlays will be 1.5% of revenue for the next couple of years before heading upward and reaching 2.5% five years from now, according to our prediction. Depreciation and amortization as a percentage of revenue is being kept at 1.5% from 2013-17.
For gross margin, 2012's figure of 22.3% was an outlier, so we've lowered it to a more achievable 20.5%, though that would still exceed the yearly average of 19.3% back to 2008. Also, we've pegged products as 80% of the total cost of revenue and services at the other 20%.
On the cash flow statement, the most notable items are capital spending, where we built our expectations using the average of the last five years, and acquisition activity, for which we are assuming a gradual decline. Along with cap ex, averages were used for several other lines, including the provision for doubtful accounts, financing receivables and accounts receivable. In terms of cash flows from investing activity, we also relied primarily on averages for the forecast.
As for the DCF itself, key entries and assumptions include a 1.85% yield on the 10-year note, a target debt-to-capital ratio of 51% and a cost of debt, based on the average rate Dell pays, of 4.5%.
No one and no model can predict the future with certainty. You might guess right, but five years or even five minutes from now are unknowns. However, there is utility to this undertaking, and it's bigger than any price target if it forces you to think about how your money is being used by a company's management.
We can't go step by step here, but we'll explain where we got started and how you can, too. To begin, look at the past. We're presenting an express version of the Dell model and using full fiscal years, so we need 10-Ks. To get more detailed -- and you can get much more detailed -- pull the 10-Qs for every quarter and read other regulatory filings (Dell's recent documents are here). We went back five years, though one could go back even further. We read the management discussion and analysis for clues about how the company sees its prospects. Always look for guidance about the next year or years ahead, and read older versions to see how accurate the executives were.
Think about the industry, the U.S. and global economies and rates. Do you believe they'll improve, decline or be stuck in neutral? On the income statement, are revenue and profits directionally favoring up or down in past years? Consider what would make the trend continue or reverse. Same for expenses and margins.
Study the competitors. Is the story they tell better or worse than your company? Start building assumptions about the business and its future, asking what the risks are to your predictions and whether you're perhaps being overly pessimistic or optimistic. Move to the cash flow statement, where you'll start with net income and build down the sheet. Again, look for trends. If there are none, consider using an average. Then on to the balance sheet, where you'll begin with cash and fill in your bets on assets and liabilities. No matter what, expect that it won't be perfect, but it is part of an education.
The forecasts produced will prove necessary for the DCF itself, where some of the inputs and expectations about interest rates will be plugged in to turn out an implied value. Different presumptions are going to produce different values, so do best case, worst case and likely case. When you're using Excel formulas and linking your worksheets, any data in one cell that's mirrored in another will automatically change, seamlessly making the alteration to all the related values.
A DCF model isn't a crystal ball -- it's a way to examine your beliefs and account for a variety of scenarios and how they could impact your stock, whether that's Dell or any company. Another person with the same tables will have different findings owing to their particular views about a firm's prospects and the broad economy. As noted above, you can use it in conjunction with sector comparisons, for instance putting Dell's price-to-earnings ratio of 7.7 against Lenovo's (LNVGY) 14.2. You can measure it a hundred ways, and we represent here the beginning.
If it gets you thinking more seriously about your investments, that's good. Question the models of others and those you put together, too. The main point is, when you part with your money, know why. You could get a clever cat or a dart-throwing chimp to pick your investments, but genuinely contemplating what makes a company worth owning is time well spent.