Discounted cash flow model (DCF) is one of the better ways to estimate intrinsic value of stocks.
This method of stock’s price valuation is used by most experts.
What makes discounted cash flow (DCF) model reliable?
The approach of DCF to estimate intrinsic value makes is so reliable. What approach?
The “performance metric” that DCF uses for its calculation is called free cash flow.
The use of the free cash flow approach makes DCF reliable and unique.
So before we dig deeper into DCF, lets understand what is free cash flow.
In lay mans language, we can say that “Free cash flow” is the real profit generated by the company.
This real profit is the “income” of the owners of the company.
Who are the owners? Shareholders.
Free cash flow (FCF) is that available cash that company can use to do the following:
- The can distribute it and make immediate money.
- They can re-invest it to further expand the business.
Free cash flow is not the same as “net profit”.
#1. Utility of free cash flow
Free cash flow is that ‘extra cash’ which good companies can use to improves ‘shareholders value’.
How to use FCF to enhance shareholder’s value?
Use FCF to do the following:
- Increase revenue.
- Improve efficiency of operations.
- Reduce cost of operations.
- Buy-back shares from market.
- To distribute dividends.
- Reduce debt.
A company which has ability to generate “higher” FCF is consider better.
But FCF is not “net profit”.
There are companies which report positive net profit, but their FCF is negative.
Such companies add no value to their shareholders.
In long term valuation of such companies is bound to go down.
Any company, which is maintaining a positive ‘free cash flow’ deserves attention.
#1.1 The bigger the free cash flow, the better?
The size of “free cash flow” gives only half the picture about the profitability of the company.
One needs to factor-in the concept of “free cash flow yield” to get a better realisation of profitability.
Which company is more profitable?
- FCF is $10 per share.
- Stocks price is $100 per share.
- FCF is $2.5 per share.
- Stock price is $12 per share
To buy one share of Company-A, one need to spend $100. What will be the return?
The return in terms of FCF will be $10.
To buy one share of Company-B, one need to spend $12. What will be the return?
The return in terms of FCF will be $2.5.
What is their FCF yield?
- Company-A, FCF Yield is 10% (10/100).
- Company-B, FCF Yield is 20% (2.5/12).
In this example, Company-B is more profitable.
Though “A” is generating 4 times more FCF than “B”, but on basic of FCF Yield, we can say that B is a more profitable company.
#2. Estimate intrinsic value using DCF
Investors must look at last 10 years financial statement of companies.
The last 10 year data will help is estimation of its intrinsic value.
But before one can think of intrinsic value, there are two important numbers to be dealt with before.
- Free Cash flow (FCF).
- Free cash flow (FCF) growth rate.
FCF is not directly reported in companies financial reports.
It needs to be calculated by self.
The next step is to estimate, how the fast the FCF will grow in future.
This growth rate also needs to be estimated.
Based on last 10 years data, one can make a careful guess about the possible future FCF growth.
Lets see how we can use DCF to estimate intrinsic value of stocks.
#2.1 Calculate past Free Cash Flow (FCF) for past years
A company which has maintained positive free cash flow in the past is most likely to continue to do the same in the future.
Hence calculation of free cash flow of last 10 years is necessary.
How to calculate free cash flow?
Free Cash flow = Net cash from operating activity – CAPEX
- Net cash from operating activity – available in cash flow statement.
- CAPEX – available in cash flow statement.
#2.2 Calculate past Free Cash Flow (FCF) Growth Rate
It is also important to check if the FCF has increases or decreased with time.
Growing FCF is what investors would like to see in its stocks.
Maintaining a positive free cash flow is anyways good.
But if that positive FCF is also growing with time, it is like an icing on the cake.
Like a negative FCF is not acceptable, a negative FCF growth is also not desirable.
Negative growth rate means the company is losing its competitive advantage to its competitors.
Discounted cash flow (DCF) model values a company higher which has following three attributes:
- Positive FCF.
- High FCF yield.
- High FCF growth.
#2.3 – Forecast Future Free Cash Flow (FCF) for next 10 years.
In this step of intrinsic value estimation, we will make an assumption.
“All other conditions remaining same, company is likely to replicate its past FCF trends in future”.
What does it mean?
Suppose a Company-A has FCF of $2 per share in year 2008.
Today in year 2018, its FCF is $10 per share.
At what rate the FCF grew in last 10 years?
CAGR @17.4% per annum.
Taking some factor of safety, we can assume that Company-A will likely to grow its FCF at 15% per annum in future as well.
How much factor of safety is enough?
There is not hard and fast rule.
My stock analysis worksheet consider following 10 year data to arrive at a reasonable factor of safety:
- Cash flow from operations growth rate
- EPS growth rate.
- Net worth growth rate.
- Sales growth rate.
- Operating profit growth rate.
These stock metrics, coupled by its “Median” value and then an additional safety factor of 75%.
I have found this way of predicting future FCF growth to be more reasonable. Why?
Because it encompasses almost all aspects of “business growth factors”.
Why it is necessary to built-up these metrics to predict future FCF growth?
Because FCF growth is dependent on them.
When a combination of Sales, net worth, cash flow, operating profit, EPS etc grows, FCF will surely benefit.
#2.4 – Forecast Future Free Cash Flow (beyond 10th year)
This is called terminal value.
What we have calculated in step-2.3 above is free cash flow of only next 10 years.
But company will not cease to operate after the end of 10th year.
The cash flow generated by the company from 11th years onwards till infinity is called its terminal value.
In the process of estimation of companies intrinsic value, correct estimation of terminal value is more important.
To calculated terminal value of a company one must use the following formula:
Terminal Value = FCF10th x [ (1+g) / (WACC – g) ]
- g = FCF growth rate assumed after 10th year (3%)
- WACC = Weighted Average cost of capital = Cost of Equity + Cost of Debt
- WACC = E/(E+D) x Ce + D/(E+D) x Cd
#2.4.1 Terminal Value
Calculation of terminal value must be done with utmost case.
Any small overestimation on underestimation will greatly change the terminal value.
Generally people overestimate the terminal value.
As we cannot forecast future cash flow with full certainty, hence it is advisable to keep terminal value calculation as modest as possible.
People generally make mistake in the following parameters:
- Rf – Giving higher values to “Risk Free Rate” &
- Rp – Giving higher values to the “Risk premium”.
Rf and Rp are a very important element of Terminal Value estimation.
My suggestion is to keep these values as “conservative” as possible. Example:
- Risk free rate below 6% and,
- Risk premium below 5%.
#2.5 – Calculated Present Value (PV) of Future FCFs
Which are future FCFs?
- FCF for next 10 years (year 1st, 2nd, 3rd, 4th,….,10th)
- Terminal Value beyond 10th year (year 11th).
In this step one has to calculate the “Present Value” of these FCF’s
To calculate present value, all the above 11 FCF needs to be suitably discounted.
Here it is very important to pick a right discounting factor.
What will be the discounting factor? WACC.
Discount factor = 1 + (WACC+1)^n, (n = 1, 2, 3, 4, 5….etc no of years)
Weighted Average Cost of Capital (WACC) means Weighted Average Cost of Capital.
- WACC = Cost of Equity + Cost of Debt
- WACC = E/(E+D) x Ce + D/(E+D) x Cd
- See step4 for the meaning of acronym’s E, D, Ce, & Cd.
One must use this below formula to calculate the discounting factor for each year:
Multiplying the discounting factor with future FCF’s & TV will give us the present value of all future cash flows.
#2.5.1 – Calculate “Total Value” Per Share of Company
Sum of present value (PV) of all future cash flows is the ‘total value’ of company.
Total Value = Present Value of (FCFs 10Y + Terminal Value).
Once total value is calculated, divide this by ‘total number of shares outstanding’.
Total number of shares outstanding can be found in companies financial reports.
One can also find this data readily available on free websites like moneycontrol.com or economictimes.com etc.
Present value = Total value / no of shares outstanding.
#3 What will be the Intrinsic value?
Present value of all future free cash flows, as calculated in Step 2.5 is the intrinsic value.
Comparing this calculated intrinsic value with current market price is important.
When intrinsic value is above market price, stock is said to be undervalued (good buy).
When intrinsic value of is below market price, stock is said to be overvalued (not good buy).
Calculation of intrinsic value of stocks using DCF model is not easy.
The Discounted Cash Flow (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
The limitation is the detailed calculation, which is both tough and lengthy.
Hence I have a developed a model for myself.
I call it My stock analysis worksheet.
This worksheet tiers to estimate intrinsic value of stocks based on DCF and other methods.
Though this worksheet cannot be be treated as an investment advice.
But one can still use it to get a feel of how DCF model works.