Valuing Quality Compounders

How to find the fair price of a stock

If you haven’t read the past posts in this series start here before reading today.

Hey investor 👋,

Welcome to today’s Deep Dive.

This is the fourth part of my free 5-part Deep Dive series on how to analyze stocks, in preparation for the release of my upcoming eBook, How to Analyze Stocks. This eBook is my full framework and process. It will teach you how to find, analyze, research, value, and profit from high-quality stocks. Premium subscribers will receive this eBook for free.

This eBook will teach you how, and my paid analyses will do it for you.

At this point, you’ve learned how to find, research, and analyze the business of high-quality stocks. But how much is this business really worth? And how much should you pay for it, in order to make the best return?

Let’s get into it. (14 min read)

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Today at a glance:

1. An honest talk about fair value

2. The way of the DCF analysis

3. Peer-to-peer and multiples

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An honest talk about fair value

I wanted to start today’s post off with a large disclaimer about what we will be talking about. Most fair value, valuation, or any fancy lever you try to pull to value a stock—it’s all assumptive. We can’t predict the future. Neither you nor me. When we talk about discounted cash flow and multiples and future growth—these are all assumptions, not predictions.

That being said, while we can’t be sure about anything, we can estimate. And with conservative estimates, we can get to a rough roundabout valuation on what you should pay for a business to get the returns you want. Spending time researching a quality business using the steps outlined before today could all be butchered just if you buy a business at a bad price.

Quality of a business matters, but so does price.

When we talk about fair value and valuation, we aren’t looking to be wizards—we’re looking to be rational investors.

Today’s step in the stock research process is to find the reasonable growth expectations of a business over the period you wish to hold it, adjusted for error, to give us a number we can base our buying off of. Never, ever start on the valuation step without proper research and analysis beforehand.

And so with this in mind, off we go.

The way of the DCF analysis

I try not to spend much time on valuation. Because it seems the more time I spend, the more irrational I tend to get with the numbers. And this is me being openly honest with all of you: Valuation is the step I spend my time on the least, and this post will reflect that. But it’s about what I do with the limited time that will make this very important.

Like many, my valuation process starts with a simple DCF analysis.

The DCF analysis, or discounted cash flow, is a formula you can use as an investor to roughly estimate how much a business is worth based on how much it generates in cash flow for you as the owner, over the timeframe you own its shares. As we already know from the past posts in this series, cash flow is superior to all other metrics when analyzing quality and return. So this is what we’ll be using today, as always.

I run two DCFs: a forward DCF and a reverse DCF.

A forward DCF shows me how much the business is worth based on my expectations. A reverse DCF shows me how much the business is worth based on what the market is currently pricing in—this second DCF is a sort of check to see if I’m overestimating my projections.

Let’s start with the forward DCF.

Throughout this section, I’ll be using MercadoLibre as the example in the DCFs. Do not take these DCFs as actual valuation analysis. This is all for educational purposes, and the data might not be accurate (in fact, MercadoLibre’s cash flow is heavily distorted). Use it for reference only.

Both the forward and reverse DCF spreadsheets shared today are created by yours truly, and are free templates you can download to use here.

Forward DCF

Since my portfolio return goals are 12–15%, I use both 12% and 15% as the discount rate (rate of return) in two separate DCFs for both the forward and reverse calculations. Why do I do two DCFs instead of using 13.5% (the average percentage number of my return goals)? Simple: so I can gauge both goals individually for nuance.

For all of my DCFs, I use a timeframe of 5 years. And I re-evaluate every holding of mine by running these DCFs every quarter. For the inputs I use, I always try to be as conservative as possible. Because, as I mentioned above, if a stock is at a fair price, it shouldn’t take much effort to land on that conclusion. The longer you take to come to a conclusion that a stock is expensive or cheap, the more likely you are to have detrimental errors in your estimate.

Below are my forward DCFs of MercadoLibre as of Q1 2025 (12% and 15% discount rates) (click to enlarge).

12% rate of return

15% rate of return

The average intrinsic value (i.e., the worth of the business) of these two DCFs is $199.78 billion, or $139.85 billion adjusted for the 30% margin of safety.

By my inputs, we can reasonably assume that buying MercadoLibre under or around a ~$140 billion valuation will yield you a minimum of 12% annually over the next 5 years. MercadoLibre is currently trading at $130 billion as I write this. Even if growth is slightly less, the margin of safety protects you as the investor from losing much upside.

“Wait just a second, how did you get these inputs to begin with, Jacob?”

Great question. And this is a major part of running a DCF. Because, in a spreadsheet, inputs in every way influence the outputs.

This formula can, and inevitably will be (either accidentally or purposely) abused.

Starting out a few years ago, I went crazy with my inputs. I used nothing rational or any data backed by real-world expectations—just my big fat brain tweaking out numbers until the spreadsheet said the stock was undervalued. I kid you not, this is what I did. And not because I was oblivious—I knew what I was doing (for the most part)¹—but because I was ignorant.

With every DCF (and particularly for my spreadsheet template if you use it), you as the investor need to input specific values to get the result. You must find:

• Net debt of the business,

• Trailing twelve-month cash flow (FCF or OCF depending on the business at hand),

• A reasonable CAGR growth rate,

• A reasonable cash flow multiple,

• A 12–15% discount rate/rate of return (change this according to your specific goals—I would recommend a minimum of 10%, otherwise you’re projecting too close to market returns, in which case the effort of researching might not be worth it for you),

• A reasonable margin of safety (30% should be the absolute minimum, but this can be adjusted based on how sure you are of your expectations—and sureness is a product of prior research).

For the MercadoLibre DCF(s) above, my rationale behind the inputs is as follows (minus unchangeable inputs like FCF and net debt):

• A CAGR growth rate of 15% for the next 5 years.

  • This is reasonable given MercadoLibre is still growing in the high 40s percentages in revenue, and 90s percentages in FCF. (This FCF growth is not sustainable at all, and so it’s expected the business will have meaningful deceleration over the next few years. However, even if we assume growth halves every year over the next 5 years, we still end up with a 32% CAGR from here. And I feel that using 15% is still reasonable given this.)

• A 20x cash flow multiple.

  • Currently, MercadoLibre trades at 17x, so this multiple is a slight premium to adjust for what I believe to be an underappreciation towards the growth of the business. MercadoLibre arguably deserves more than 20x, but due to political instability, FX worries, and more, I can see why investors would devalue the growth. But then again, 20x is more than fair, even with these risks in mind. For comparison, Mercado’s median multiple over its history is around 45x.

• A 12–15% rate of return based on my personal portfolio return goals.

• A 30% margin of safety

  • I used the minimum required to cover my arse in the case I end up being wrong (which is always likely in the stock market), seeing as the inputs I entered are not in any way unreasonable.

Much like business research and due diligence up until this point of the research process, with DCFs and valuation analysis, you have to be just as rational, and just as educated with your inputs. With every input, ask, “Why this?” Do this, and you’re already ahead of 99% of investors.

I’ve seen people go full-blown Cathie Wood with DCFs, grossly overestimating their holdings’ worth to get it to say what makes them happy. And let me tell you: it doesn’t end well—best-case scenario, you underperform your expectations; worst case, you obliterate your hard-earned dollars. All because of negligence and ignorance. Don’t be like this, I beg of you.

You will thank me later.

But, we’re still not done. We have our expectations, but to help us in rationally understanding them we need to ask: what is the market expecting?

Reverse DCF

Are you in a relationship?

If so, imagine your significant other tells you to cook dinner. You listen, and you decide to make soup. Delicious! You throw the ingredients in, the broth—and voilà, a tasty soup. Then, you serve your partner a bowl of this soup, and they slap you in the face.

Ladies and gentlemen, welcome to the reverse DCF: the face-slapper to make sure what you’re cooking, or have cooked, is reasonable.

The reverse DCF is exactly as the name suggests. Instead of projecting future growth to see how much a business is worth today, you are just fiddling with growth rates to figure out how much is being priced into the stock based on its valuation today. This is the second and final DCF calculation for extra context to help justify (or not justify) your projections.

Below are my reverse DCFs of MercadoLibre as of Q1 2025 (12% and 15% discount rates) (click to enlarge).

12% discount rate

15% discount rate

These are the same exact values as before; same expected rate of returns and such, but this time we’re using the multiple the company is trading at. We will also be tweaking the growth rate until the “Priced-in value (Mr. Market)” line shows up to what the current market price is (again, that is $130 billion as of the time of writing). Here’s what the above DCFs tell us by averaging their values:

At today’s ~$130 billion valuation, the market only expects MercadoLibre to grow FCF by ~8% annually over the next 5 years.

We have already gone over how just in the past year FCF growth was over 90%, and how a reasonable assumptionof growth for the next 5 years (factoring in deceleration) would be 15%.

Thus, the market is heavily underpricing Mercado’s growth aspects. Meaning, MercadoLibre is well positioned to beat market expectations. And in this case, the market will, with time, rerate the stock—this gives me and you, as the investor, potential for even higher than our 12–15% projected annual returns.

My original forward DCF was very conservative given my rationale. But the market is being even more conservative with its expectations. Put two and two together from both the forward and reverse DCFs, and it tells you MercadoLibre is at a very favourable valuation. And this step-by-step framework can be applied to any valuation analysis you do on a stock.

(Full MercadoLibre analysis out next week for paid subscribers. I will detail the risks, growth, reinvestments, and full research on the company then.)

Peer-to-peer, multiples, yields

DCF analysis on both ends, as described above, usually takes a little less than an hour with prior research. That’s if I really want to get things right. But there are a few final metrics for “valuation” that I wanted to mention.

These aren’t the most accurate for getting a clear picture of valuation, but they get heavily abused by retail investors and professionals around the globe, so I wanted to give light in this section to clarify some misconceptions and to acknowledge some strengths.

The metrics in question: Peer-to-peer, standard valuation multiples, and yields.

I try to stay away from lingering too much on multiples and comparing stocks with other competitors or more, because each business is its own.

I want to lump all of these metrics together to explain where they’re valuable and why they lack in usefulness in comparison to the DCF(s) analysis above.

First, peer-to-peer.

This is a simple analysis where you take the company—let’s say Amazon—and you compare its multiple valuation with competitors. At the moment, Amazon is trading at a 33.49x forward P/E ratio, 3.43 P/S ratio, and a 0.93% FCF yield. (These are the only metrics I look at when I look at multiples.)

• P/E tells you how many years of GAAP earnings Amazon needs to make to total its valuation,

• P/S says the same but for revenue, and

• FCF yield tells you how much theoretical cash you would be paid as a percent if the company were to pay its cash to shareholders (kind of like a theoretical bond yield, but for stocks).

Many people abuse these metrics, and I’ll get into that below.

With peer-to-peer analysis, you would take these metrics and compare Amazon to its competitors. Some argue Alibaba is a major competitor to Amazon, so let’s use them for the example here.

Alibaba, at the time of writing, is trading at a 1.74x forward P/E ratio, 2.35x P/S ratio, and a 5.80% FCF yield.

“Gosh,” you say. “Amazon is way too expensive! That’s over the market’s P/E multiple of ~28x.”

And this is where the tricky part of using these metrics comes in.

The reality is that Amazon is not expensive, Amazon has no real competitor, and peer-to-peer analysis either doesn’t work or is highly inaccurate for valuing its business.

For earnings, Amazon has historically been a company of retained earnings—constant reinvestment for the sake of tax benefits, which has not allowed Amazon to appreciate its earnings in the same way other companies have. This is changing, but still. If management decided they wanted to prioritize only earnings and higher margins, this would be done swiftly. In fact, Amazon is currently experiencing earnings expansion today—growing well above 70% YoY as I write this (this will decelerate and fast, but it’s worth mentioning because in a year or two, a “high earnings multiple” will be meaningless).

Its price-to-sales is on point with industry norms, and is in no way expensive based on broad market averages (a normal range is about 1–2, and for online retailers, that’s about 3). (This isn’t some absurd priced-in revenue multiple like Palantir at over 90x.)

And as I write this, Amazon is heavily expanding into physical data centre infrastructure, which is increasing capex expenditure, which is lowering total FCF. Hence, the low FCF yield.

I like to use multiples and FCF yields, and all that jazz for glances and to gauge base-level valuation. But it really tells you nothing. Peer-to-peer is almost useless for most companies, considering every company has differences from its competitors in most markets. (Think Amazon and MercadoLibre. Both e-commerce, both completely different valuations—and also businesses. Even Apple and Samsung are not at all similar businesses as a whole, yet peer-to-peer would be a popular tool used between them and multiples would be included.)

Multiples are a great way to view quick metrics and compare, but without context, they are meaningless.

Sure, Shopify is trading at a P/E multiple of roughly 2.5x the market, but let’s add context: The S&P 500 is expected to grow EPS at ~9-12% in 2025. Shopify is (1) not worrying about earnings profitability at the moment, and (2) is growing revenue and FCF at 27% and 65%, respectively.

Context. Matters.

Don’t be so quick to judge.

The multiple might just be justified.

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And, that’s it. You know how to value a stock (at least one way that’s effective). Not with perfection, but with reasonable assumption.

Here lies the semi-finale of the How to Analyze Stocks Deep Dive series, and the beginning of the end of your amazing investing career to come. I’ll see you soon. Cheerio, friends.

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Note: Some people may have different criteria for a quality business, and that’s perfectly fine. Investing is an art, not a science. It requires some practice to get your style. You first need to know the basics, then continue developing the craft until you’re comfortable enough to consider yourself an artist. I’m not a dividend investor, value investor, or growth investor. I’d say I follow GARP (Growth at a Reasonable Price) and do so pretty well (a mix of value and growth), but my style is unique to me, and that’s what I write about. It will also evolve with time.

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Thank you for reading, partner. If you enjoyed today’s issue, share it with friends and family. I’ve placed a button below for you to do so (right underneath the paid membership line (see what I did there).

All the best,
Jacob

All of my links here.

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1. (I had absolutely no idea what I was doing.)