Discounted cash flow (DCF) is of the more accurate financial models used to estimate intrinsic value of stocks. This method of stock’s price valuation is used by experts like Warren Buffett etc.
What makes discounted cash flow (DCF) model more accurate? It is the metrics that this financial model uses makes its estimates more accurate.
Process of Discounted Cash Flow (DCF)
Before we go into the calculation part of DCF, allow me to explain the process in brief. It will help you to get an overall feel of DCF analysis in totality.
- FCF (Past): DCF process starts with calculation of free cash flow (FCF) of past 5 years. As FCF is not directly reported in company’s financial reports, hence it needs to be separately calculated by the investors. I’ve written a separate article on free cash flow calculation. You shall read it before proceeding with DCF calculations.
- (1.a) FCF Growth (Past): Once past 5 year’s FCF is calculated, these values must be used to calculate the FCF growth rate (CAGR) shown by the stock in the past. How to calculate.
- (1.b) FCF Growth (Future): Based on the past 5 years FCF CAGR, an assumption shall be made for future growth rate (CAGR). This growth rate will say at what average rate the FCF will grow in next 5 years. How to calculate.
- FCF (Future): In #1 we will get the current year’s FCF. In #1.b we will get FCF growth rate for future 5 years. Using these two numbers, we will calculate the FCF for next 5 years ahead in future.
- Terminal Value (TV): We are assuming FCF for only next 5 years. But the company will continue to generate FCF after 5th year as well. Hence, for beyond 5th years, all FCF’s generated by company is called terminal value. This must be calculated using a TV formula.
- (3.a) TV Growth Rate: To calculate TV, a suitable growth rate must be assumed first. Consider this growth rate as a rate at which the company’s FCF will grow beyond the 5th year in future.
- (3.b) WACC: We must also calculate the Weighted Average Cost of Capital (WACC) for the company. WACC will work as a “discounting rate” to calculate present value of future FCF’s & TV.
- Present Value (PV): All future FCF’s & TV must be suitably discounted to calculate their present value. Sum of all present values of future FCF’s will give the intrinsic value.
Steps of DCF Analysis
What we have seen above is only a small description of the process of Discounted Cash Flow (DCF). Now we will see more details. We will actually go ahead and do a DCF analysis for a stock.
1. Free Cash Flow (of Past 5 Years)
Free Cash Flow (FCF) is an improved version of net profit (PAT). What is easily available in company’s financial statement is PAT. But FCF must be separately calculated by the investors. Warren Buffett mentions Free Cash Flow as “Owners Income”. It was Buffett who made the use of Free Cash Flow popular for stock analysis.
To practice Discounted Cash Flow (DCF) analysis on stocks more successfully, correct estimation of company’s future free cash flow is important. Read: How to estimate free cash flow.
(1.a) FCF Growth Rate (Past)
Once the FCF’s of last 5 years is calculated, the next step is to calculate its annualised growth rate (CAGR). Calculation of CAGR is simple. I will show you how it can be done in Excel using RRI function. Check the below screen shot for details. The excel formula for CAGR is =RRI(nper, pv, fv)
(1.b) FCF Growth Rate (Future)
Based on the growth rate at which the FCF grew in last 5 years, we can assume that FCF will grow at the same rate in next 5 years in future. Hence, in the example considered, FCF growth rate for future will be 5.952% (CAGR) for next 5 years.
In case the analyst is not confident about the past growth rate being imitated in future, a suitable correction factor can be considered. Suppose the analyst in only 75% sure, in this case the adjusted growth rate will be 4.46% (=75% x 5.92%).
For example sake, let’s consider the correction factor of 100% and proceed with our calculations.
2. Free Cash Flow (Future)
In Step #1 and #1.b, we have got two critical numbers. First, free cash flow of current year (as on Mar’19). Second is expected free cash flow growth rate (CAGR) for next five years.
- FCF (Mar’19): Rs.15,985 Crore.
- FCF Growth (next 5 years): 5.952%.
We will use these two numbers to extrapolate and forecast an expected FCF for next 5 years. Let’s see how the future FCF numbers looks in excel.
- FCF (31-Mar-21) = FCF (31-Mar-20) * (1+FCF Growth Rate).
- FCF (31-Mar-21) = 16.937 * (1+5.952%) = 17,945
3. Terminal Value (TV)
To calculate terminal value, we will use the FCF of 5th year (31-Mar-24) as shown in the above example (Rs.21,344 Crore). This will work as a base year for all future cash flow which this company will ever generate (called terminal value).
But to calculate TV we will need two more number: (a) TV growth rate, and (b) WACC.
The formula for terminal value is, TV = FCF / (WACC – Growth Rate). Let’s see how Terminal Value (TV) numbers looks in excel. In this case the terminal value will be: TV = 21,344 / (9.11% – 3.5%) = 3,80,461.
(3.a) TV Growth Rate (expected)
TV growth rate can be assumed to be at leat 3.5% per annum. I’ve intentionally kept the number so low. This gives us a more conservative intrinsic value figure.
[P.Note: The lower is the TV growth rate, smaller will be the intrinsic value.]
(3.b) Weighted Average Cost of Capital (WACC)
What is WACC? Check here. The Excel working of WACC will look like this:
- WACC = Cost of Equity + Cost of Debt.
- WACC = E/(E+D) x Ce + D/(E+D) x Cd.
- Risk Free Rate (Rf): The yield of 10 year government bond can be used as risk free rate (Current Rf).
- Stock Beta (B): It is a measure of stock’s price volatility with respect to the benchmark index (Nifty, Sensex, BSE 500 etc). You can get any stock’s beta from economictimes.
- Risk Premium (Rp): This is the investors expected returns over and above the risk free free rate. For example I’ve assumed it as 6%.
- Pre-tax cost of debt (Cpt): This is the interest rate that a lender charges for loan in general to the company. I’ve assumed here that, the company is paying an interest of 8.2% (1.5% above Rf) on its loans.
- Effective Tax Rate (Tr): All companies need to pay tax to government on its profit. Effective tax rate (Tr) is the average income tax paid but the company on its profits. For example I’ve assumed it as 25%.
- Total Equity (E): This number will be available in company’s balance sheet. Sum of share capital and reserves is the total equity.
- Total Debt (D): This value is also available in company’s balance sheet. Sum of all long term and short term borrowings will account for the total debt of the company. Read: debt free companies.
3. Present Value (PV)
To calculate present value, all the above 6 cash flows needs to be suitably discounted. What will be the discounting factor? WACC (calculated in #3.b).
Formula: PV = FCF / (1+WACC)^(N).
- FCF: Free cash flow or terminal value (say 20,145).
- WACC: Weighted Average Cost of Capital (say 9.11%).
- N: Number of years ahead in future (say 4 Years)
- PV: Present Value (=20,145/(1+9.11%)^4 = 14,214).
Let’s see how the whole calculated of present value calculation looks in excel:
Total Present Value (PV) of all future cash flows in this example is Rs.2,98,737 Crore.
Now that we have calculated the Present value of all future cash flows of the company, how to check if it is undervalued or overvalued?
To do this check we’ll need to do some more calculations. We will have to convert the present value number to present value per share (PVPS). How to do it? By use of the below formula: PVPS = Total PV / No of shares outstanding.
Once PVPS is calculated this becomes the intrinsic value per share. Now we can compare intrinsic value with the current price of the share. If the current price is less than intrinsic value, the stock is undervalued. If current price more than intrinsic value, the stock is overvalued.
Concept of Margin of Safety
The accuracy of the calculated intrinsic value is dependent on two main factors, (1) On the estimated future cash flows, and (2) on the calculated WACC.
In case an investor is 100% confident of his calculation of these two numbers, he/she apply a multiplying factor of one (1) on the calculated intrinsic value.
In case the confidence is not so high, using a suitable multiplication factor is advisable. I generally use a multiplication factor of 2/3rd (0.667) on my estimates.
I first apply the multiplication factor on the calculated intrinsic value and then compare it with current price to judge if the stock is undervalued or not.
Calculation of intrinsic value of stocks using DCF model is not easy for all. But this is also true that DCF method is one of best ways to estimate intrinsic value of stocks.
But as you have seen, estimating intrinsic value using DCF involves several steps. Moreover, it also needs a deeper understanding of companies financial reports.
The procedure is like fool proof but it has its own limitation. Often the limitation is on the side of the investor’s understanding of the numbers in the financial reports.
I have a developed a model for myself. I call it My stock analysis worksheet. This worksheet can estimate intrinsic value of stocks based on DCF and other methods.