TBH, I have never been a fan of Discounted Cash Flow (DCF).
I know that financial institutions, private banks, and family offices swear by them.
Yes, DCF provides the most detailed and the most holistic way to value a stock. But there is a saying in Mandarin “人算不如天算” which translates to “No humans can predict like the God(s)”.
To support my words and thoughts, I am very sure that most financial models done on the most magnificent stock out of all the Magnificent Seven – NVIDIA Corp (NASDAQ: NVDA), would not have predicted today’s share price appreciation.
As AI drives NVDA and its AI cohorts to dizzying heights, the million (or billion) dollar question is, what is NVDA’s stock valuation, and is it still a good buy at its current price?
I hope this article helps not only to answer what NVDA’s fair value is but also serves as a crash course for me to learn and demonstrate my DCF modeling (hint: this is a crash course for me!)
The steps of doing a DCF
The DCF involves 4 steps. Below are the 4 steps:
- Forecasting the unlevered free cash flow
- Calculating the terminal value, and discounting the cash flow to present value at the Weighted Average Cost of Capital (WACC)
- Adding the value of non-operating assets (idle cash) to the present value of unlevered cash flow and subtracting debt and other non-equity claims
- Dividing the net present value equity against the diluted outstanding shares.
Chim right? In layman’s terms, the future value of cash is worth less than it is today. That is why when considering future cash flows of a company like NVDA, you apply a discount factor to find out their present value.
1. Deriving the unlevered free cash flow
We will be using unlevered free cash flow for this DCF exercise.
What is Unlevered Free Cash Flow (UFCF)? It is a company's cash flow before taking interest payments into account
Why? Because it makes it easier to do an apple-to-apple comparison without the constraint of each company’s capital structure (debt and/or equity funding).
What is Debt Vs Equity Funding? Debt funding is when a company raises funds by borrowing money through selling debt instruments (eg bank loans or bonds). Equity funding involves selling a portion of equity (shares) in the company.
The formula for Unlevered Free Cash Flow (UFCF) is as below:
It is also worth mentioning the NVDA that we are looking at right now is vastly different from the NVDA a few years back. Gross margins are at a ludicrous 76% for the latest quarter!
And to top off the icing on the cake, due to NVDA’s Foreign-Derived Intangible Income & R&D initiatives, it gets to enjoy a lower effective income tax rate.
The “conservative” unlevered free cash flow for this exercise is as follows:
Some key assumptions:
- Revenue growth is 54.43% YoY for 2025, 34% for FY 2026, 20% for FY 2027, 15% for FY 2028 and 12% for FY 2029. This is in line with or even much more conservative than analysts’ estimates.
- Stock-based compensation is set at 10% of revenue, while R&D expenses are at 15% of revenue.
- Depreciation and amortization at 12% of total long-term assets, growing at 20% p.a.
- Changes in net working capital fixed at USD 3.5 bil
- CapEx fixed at USD 2.0 bil.
2. Calculating the terminal value & discounting everything to the present value
Yes a stock like NVDA can bring a crazy amount of cashflow if held for a long period. However, the longer you hold it, the more discounting is needed for the present value of that cash flow.
The Weighted Average Cost of Capital (WACC) and discount rate used for this simulation is 10%, which is very conservative for NVDA in light of a potential AI tipping point. The forward 5-year unlevered free cash flow is discounted to obtain their present values and summed up to obtain the sum of USD 213.2 billion.
What is Weighted Average Cost of Capital (WACC)? Weighted average cost of capital (WACC) represents a company's average after-tax cost of capital from all sources. In layman terms, it is the amount of money it must pay to finance its operations.
Next is the step of calculating the terminal value. The average long-term GDP growth is 4%, thus using that as the long-term growth rate.
What is Terminal Value? Terminal value (TV) is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period.
We then calculate future cash flow beyond 2029 by dividing it by the difference between the discount rate and the long-term growth rate.
TV = (FCFn x (1 + g)) / (WACC – g)
Lastly, discounting it to the present value, to obtain USD 835 billion,
3. Adding idle cash and minus off debt
NVDA has total cash and short-term investments of USD 25.98 billion and a debt level of USD 11 billion (inclusive of capital leases).
By adding the sum of present values of the 5-year Unlevered Free Cash Flow and the terminal value, we obtain an enterprise value of USD 786 billion. Adding the cash and minus the debt, we get a net equity value of USD 1.06 trillion.
4. Equity value per share basis
As of the latest figures, NVDA has a total weighted average outstanding shares of roughly 2.5 billion shares.
With a net equity value of USD 1.06 trillion, we then divide it with the outstanding 2.5 billion shares, to obtain a value of USD 425.24 per share.
Compared to NVDA’s current share price of USD 822.79, on paper, we are looking at an overvaluation of around 1.93x.
Even if I were to do a trailing P/E ratio check, we are looking at a P/E ratio of 68x. And I have come across even more bearish DCF models than mine, and as well as models that are way more bullish.
And by now I can tell you, it is not that straightforward nor easy to get each assumptions right in terms of forecasting each single moving part that goes into a DCF model.
The practitioners and most of Wall Street swear by it, while it frustrates me. Don’t get me wrong, the rationale makes sense, but making assumptions about what could happen in the future and using a sophisticated valuation methodology does not mean that every model can predict where the stock should be at its current price.
Verdict
Just by tweaking any moving part in the DCF model, it may point a stock’s valuation to undervalued or overvalued territory. A DCF model can help complement other valuation methods to help investors gauge the approximate intrinsic value of stock before making any decisions.
The game of valuation and probability can get even more sophisticated by doing a Monte Carlo simulation. However, this might be beyond the understanding of the general public.
My advice? Valuation is important, but so is understanding the business and value that a company offers. Neither a DCF nor trailing or forward P/E can save you from black swan event-induced correction.
I think NVDA’s valuation is pricey, but not preposterous, given its potential. But I would wait for any dips to USD500-600 to add or top up. If not, I am happy to hold whatever I have right now.
p.s. I welcome other DCF models and assumptions if any of you have gone through the process of building one. Or if you are a private equity or family office looking to enlarge your team and am impressed, feel free to contact me 😀