# Free Cash Flow Analysis of Indian Stocks

Why free cash flow analysis is essential? It is the free cash flow (FCF) that helps us to estimate the intrinsic value.

A stock which generates a positive free cash flow, and also grows at a reasonable speed, will have a high intrinsic value.

Similarly, a stock which has negative free cash flow, will show zero intrinsic value.

Of course, when we are talking about free cash flow and intrinsic valuations of stocks, we are indirectly referring to DCF Model

I use my stock analysis worksheet to estimate intrinsic value of my screened stocks

In this blog post, I will share the details of free cash flow analysis of a stock called Adani Ports

• First, we will estimate its Free Cash Flow (FCF).
• Second, using the FCF we will try to estimate its “intrinsic value”.

## #1. Calculating Free Cash Flow (FCF)…

In the process of valuation of stocks, free cash flow is the most important ingredient.

What I mean by “ingredient”? Contributing factors.

There are three main contributing factors in estimation of intrinsic value of stocks

• Free Cash Flow (FCF),
• FCF Growth Rate (g), and
• Discount Rate (R).

But why I call free cash flow as the “most important” ingredient?

Because unless FCF is a positive number, even bigger growth rates and discount rates will make no difference.

If FCF is negative or zero, its “intrinsic value” will be zero.

Hence, this makes free cash flow calculation crucial.

• A right FCF will give a better intrinsic value.
• A wrong FCF will give a wrong intrinsic value.

### #1.1 How to calculate free cash flow for stocks?

In terms of methods, there are two. We will estimate FCF of Adani Ports using both the methods.

• Method 1 – “Cash Flow From Operations”.
• Method 2 – “Reinvestment of Capital”.

Why I will use both the methods, and which is more preferable?

In my stock analysis worksheet, both these methods are used to estimate intrinsic value of stocks (DCF Model).

I use both the methods to make sure that we do not miss any important point related to capital reinvestment or cash flow generation.

After all, both these factors (cash flow and capital reinvestment) greatly effects a companies financial health in long term.

Which method is my favourite? The real answer is “it depends”.

A company which is able to generate cash fast (like retail, FMCG etc), will show better numbers in Method-1.

A company which is not able to generate cash fast (like engineering etc), will show poor numbers in Method-1. Hence to give such companies a chance, use of Method-2 is advisable.

But my stock analysis worksheet cannot differentiate between fast-cash-in company and a slow-cash-in company, hence a weighted average is taken.

This is done to make sure that the effect of both cash-flow and capital reinvestment gets build-in the “final intrinsic value”.

#### #1.1.1 Free Cash Flow (Method -1)

Here we will use the “cash flow generated from companies operations” as the basis.

Lets call the cash flow generated from operations” as CFO.

Formula for FCF will be as below:

FCF = CFO – CAPEX

CAPEX = Net Capital Expenditure.

We will first pull needful numbers from the annual report of Adani Port.

We will use these numbers to calculate FCF.

Which numbers to pull?

• CFO (Net cash from operations).
• CAPEX (A – B – C)
• A – Purchase of Capital Assets
• B – Sale of Capital Assets.
• C – Depreciation and Amortisation.

In last 2 years, Adani Ports has generated a free cash flow as below:

In FY ending Mar’18: Rs.3,210.97 Crore.

In FY ending Mar’17: Rs.2,232.09 Crore.

Looking at these two numbers, now we have to assume, what will be the free cash flow of Adani Ports in FY ending Mar’19.

How to make this guess?

This is where my stock analysis worksheet becomes useful. It can forecast the future growth rate of the company.

How it forecasts? Based on companies “retention ratio” and “reinvestment ratio”.

Based on my worksheet, FCF growth rate estimated for next 1 year is 28%.

How certain I am about future growth rate estimation? For sure, when we are looking ahead in future, nothing is certain.

Hence I would like to build-in a uncertainty factor of 85% in my calculation. What does it mean?

It means, if my worksheet is estimating FCF growth of 28%, I will consider only 85% of 28 = 23.8%.

Hence, FCF of Adani Ports for FY ending Mar’19 will be, as below:

#### #1.1.2 Free Cash Flow (Method 2)

In method 2, we will use the concept of reinvestment of capital.

This analysis has slightly more depth than method 1. Why?

Because the way we arrive at free cash flow here looks more logical and practical. How?

Because of the following scheme of things happening in the company:

First, the company generates net profit (PAT).

How this net profit gets used up by the company?

1. To increase companies assets (CAPEX).
2. To fund the “increase in working capital” (IWC).
3. To pay off debt (Debt Paid).

In addition to the above 3 stated utilisation of PAT, the company may also avail new debt from the market.

Moreover, the companies non-cash expense of Depreciation and Amortisation (D&A) also gets added to companies net profit.

So what is happening here with companies PAT is shown below:

Cash-in: PAT + D&A + New Debt.

Cash-out: CAPEX + IWC + Debt Paid.

We will use this infographic to shown you a formula to calculate free cash flow:

FCF = Cash in – Cash out

FCF = (PAT + D&A + New Debt) – (Capex + IWC + Debt Paid)

So again we will pull-up numbers of the Annual Report of Adani Port.

We will use these numbers to calculate FCF.

What numbers we will pull?

• D&A Expense.
• Proceeds from Long Term Borrowings (New Debt).
• Repayment of Long Term Borrowings (Debt Paid).
• Net Profit (PAT).
• Purchase of Fixed Assets (PFA).
• Sale of Fixed Assets (SFA).
• Current Assets (CA).
• Current Liability (CL).

By analysing data of last two financial years, free cash flow generated by Adani Ports in last FY is Rs.4,758.56 Crore.

What will be the free cash flow of Adani Ports in next FY (Mar’19).

How to make this guess?

This is where my stock analysis worksheet becomes useful. It can forecast the future growth rate of the company.

FCF growth rate will be 85% of 28 = 23.8% (See #1.1.1 above).

Hence, FCF of Adani Ports for FY ending Mar’19 will be, as below:

From the above two methods, we have two different free cash flow numbers for Adani Port.

• Method_1: Free Cash Flow is Rs.3,672.22.
• Method_2: Free Cash Flow is Rs.5,891.10.

## #2. Estimating Intrinsic Value…

In #1 above we have calculated free cash flow for Adani Ports.

Now we will try to estimate intrinsic value of this stocks using a formula.

What formula we will use?

Intrinsic Value = Terminal Value = FCF *(1+g) / (R-g).

• g = Free Cash Flow Growth Rate.
• R = Discount Rate.

#### #2.1 FCF growth rate (g)…

This is the growth rate at which the Free Cash Flow of Adani Port is expected to grow in future.

What I mean by future? Next 1 year, 3 year, 5 year, 10 year, what?

Here future mean, for the full life span of the company.

A company like Adani Ports doesn’t do business for 5 or 10 years. They will be in the industry for at least next multiple decades.

So what we are asked to do here is to estimate the FCF growth rate for the complete life span of Adani Port

This must be difficult, right? Because forecasting growth rate for even one year in future is difficult. Here we are forecasting growth rate for several years in future. What to do?

Play safe. Assume a very modest growth rate.

My suggestion will be:

FCF growth rate of 5%.

Also called terminal growth rate.

#### #2.2 Discount rate…

What should be the discount rate? There are two ways to do it:

• Discount rate = WACC.
• Discount Rate = 8% (Expected Rate of Return).

What is WACC? Weighted average cost of capital.

To know how to calculated WACC, refer this formula.

My stock analysis worksheet makes it easier to estimate WACC.

But if you do not want to get into so much number crunching, there is a easy way out.

Pick a fixed discount rate of 6%. Why 6%?

Because this is the rate of returns that we expect from our stock (Adani Ports).

But is 6% not too less? Yes.

But unfortunately we cannot take a better value. Why?

Lets see a formula for expected growth rate:

Growth Rate = Rf + B x Rp

• Rf = Avg. Risk Free Rate for next 50 years (5%).
• B = Beta for Adani Port = 1 (say).
• Rp = 3% (as time horizon is too far in future).

Expected Growth Rate = 5% + 1*3% = 8%.

#### #2.3 How to Calculate Intrinsic Value?

Now we have the following numbers in our hand:

• Free Cash Flow:
• By Method_1: Rs.3,672.22 Crore.
• By Method_2: Rs.5,891.10 Crore.
• FCF Growth Rate: 5% p.a.
• Discount Rate: 8% p.a.

How to calculate intrinsic value? By use of this formula:

Intrinsic Value = Terminal Value = FCF *(1+g) / (R-g).

Method_1:

FCF = Rs.1,28,528 Crore

Method_2:

FCF = Rs.2,06,188 Crore

Intrinsic Value of Adani Ports is between Rs.128,525 and Rs.206,188.

How to know if Adani port is undervalued or not?

Compare the Intrinsic Value of Adani Port with its current market capitalisation.

Market Capitalisation:

MCap = Rs.77,236.15 Crore

Intrinsic Value

1,28,528 < FCF > Rs.2,06,188 Crore

From the above comparison it looks like Adani Port is undervalued.

It is also essential to maintain a “margin of safety”.

1. Jeevan says:

Thank you so much for your posts, it gives lot of knowledge. I have question on Free cash flow calculations. I am trying to find where these four values available in cash flow statement but i could not spot it, i have checked in moneyControl and Economics time reports.
Proceeds from Long Term Borrowings (New Debt).
Repayment of Long Term Borrowings (Debt Paid).
Purchase of Fixed Assets (PFA).
Sale of Fixed Assets (SFA).

• Mani says:

• Jeevan says:

Thank you so much

2. Dipankar Hazra Banerjee says:

Nice Article but I think there might be a few typos:-
Method 2
1)L=I+C+E not C+E+G
2)Working Capital (J) = G-H not G-I

• Mani says:

Thanks a lot for pointing. It was an oversight.

3. Dipankar says:

Why is the Capex different in method 1 & 2 with the same data?

• Mani says:

Different method has been used to arrive at Capex.

• Dipankar Hazra Banerjee says:

4. Ram says:

In the FCF method 2 table
WC = Current Liabilities – Net Profit (Instead of CA – CL) and
Cash in= D&A + New debt + CA (Instead of Cash-in: PAT + D&A + New Debt.)
Please Clarify or this is a Typo Error.

• Mani says:

Thanks for asking. I will request you to kindly read the blog post. The concept has been explained.

• Ram says:

I just followed all your postings/method recently. Very Useful. Thankyou sir.
Sorry I didnt get your Reply right. Do you want me to post it in a different place If I am correct. Let me know. Thank you.

• Mani says: