The Concept of Intrinsic Valuation of Stocks and its utility for stock investors

The Concept of Intrinsic Valuation of Stocks - image

What is intrinsic valuation? It is a method based on which one can “allocate a value” to business based on its fundamentals.

Which fundamentals of business are more used in intrinsic value allocation? Three things:

  1. Its ability to generate free cash flow (FCF).
  2. Future FCF growth potential.
  3. Risks associated with the business. 

The more is the FCF & growth the better. The smaller is the risk the better. 

These are the three business fundamentals that can be used to allocate a value to any business. 

But what is the need? Why to take the “pain” of value allocation?

Yes it is a pain. Why?

Because valuation of a business is not an easy thing to do. It requires knowledge, time and effort.

But a person who is interested to buy stocks of good business must take this pain. 

Why value allocation…

In terms of stocks, value allocation is necessary. Why? 

Because the price at which shares are sold in the market are often overvalued. 

At a given point in time, 95% of all stocks (representing a good business), trade at overvalued price levels. 

If a person will buy these stocks, no doubt they will get hold of stocks of good companies, but at a bad price

Yes, buying stocks at overvalued price levels is a bad price to buy. So what?

Let it be a bad price, but as long as it represents a good business, it will always make money for its shareholders. This is the way most of us think, right?

But this thought process is wrong.

No matter how good is a business, if its stocks are bought at overvalued price levels, there are almost cent percent chances of loss in times to come.

This is where “value allocation” comes for our rescue. 

Value allocation is a process of estimation of “true value” of a business. How it helps?

If market price is more than its estimated true value, stock is overvalued. One must avoid such stocks. 

No matter if the stock is of Apple, Samsung, Microsoft, Coca Cola etc, overvalued stocks will invariably lead to losses.

How to allocate value…

Value allocation of business can be done using DCF model. 

Discounted cash flow (DCF) model is one of the way to value stocks of a business.

DCF presents a mathematical model using which one can value stocks of a business. 

So DCF can value any business? No. 

DCF can estimate intrinsic value of only those business, whose assets generates free cash flows. 

How DCF values a business? In two main steps:

Sum-total of all present values calculated in second step, gives the intrinsic value of a business. 

Why conversion of future cash flows to present value is necessary?

This is a way to adjust future cash flows for any risk.

What is the risk?

Remember, we are talking about things that is going to happen in future (future cash flows).

No body can forecast future with certainty, right? This lack of certainty builds in the risk. 

What we are uncertain about? Devaluation of money with time. What is the logic?

A Rupee in hand today is worth more than a Rupee in hand after one year…read more about time value of money here.

Risk adjusted value…

It is important to understand the “associated risk” factor while dealing with future cash flows. 

I will try to make the concept clear with help of an example

Suppose your company decided to offer a bonus plan to you.

The offer is like this:

  • Take Rs.100,000 today, or
  • Take Rs.105,000 after one year. 

What will be your pick?

Upfront it looks like, waiting for 1 year is more lucrative as you are earning Rs.5,000 more. 

But consider this, suppose you took Rs.100,000 today and put the whole money in bank’s fixed deposit. 

In terms of today, a 1 year bank deposit can easily earn 7.25%. 

It means, after one year your Rs.100,000 will become Rs.107,250.

So coming back to the bonus plan, which alternative is more profitable?

Take money today and investing all of it yourself in FD. 

How does this example explain the concept of “risk adjustment”?

In term of this example, Rs.100,000 in hand today is worth more than Rs.105,000 earned after one year. 

How you can make this conclusion? In two steps:

  • Step #1 – You knew that bank FD could earn you 7.25% p.a.
  • Step #2 – You knew that present value of Rs105,000 earned after 1 year has value less than Rs.100,000.

In other words, by discounting Rs.105,000 @7.25% (for 1 years period) is less than Rs.100,000. How it is done? By using a formula.

What is the formula?

PV = FV / (1+r)^n = Intrinsic Value

  • FV = Future Value = Rs.105,000.
  • r = Discount rate = 7.25%.
  • n = Time in years = 1 year. 

PV = 105,000 / (1+0.075)^1 = Rs.97,902

The Concept of Intrinsic Valuation of Stocks - IVFormula
Constituents which builds intrinsic valuation

Risk adjusted cash flows and intrinsic value of stocks…

Suppose there is a company which promises to generate following free cash flows in time to come. 

  • 1st year: Rs.1.00 Cr.
  • 2nd year: Rs.1.10 Cr.
  • 3rd year: Rs.1.20 Cr.
  • 4th year: Rs.1.35 Cr.
  • 5th year: Rs.1.45 Cr.
  • All years after the 5th year: Rs.18 Cr.

What should be the price you should be willing to pay for this stock?

To answer this question, what we have to do? 

Apply the DCF model to value this business. How to do it?

  • First, list down all future cash flow (we have these numbers).
  • Second, it calculates present value of all future cash flows. 

To calculate present value, we will need a discounting rate. 

Discounting rate…

What discounting rate we can choose here? Can we use 7.25% p.a. again?

No, we will have to do with a smaller number. Why?

Because 7.25% is interest earned on a 1 year FD. 

But when it comes to stocks we must first answer, how long we will like to hold on to this stock?

The answer could be as tabulated below:

Years13710
FD Interest7.25%7.15%7.00%6.85%

So you can see that, with increase in holding time from 1 to 10 years, the FD interest rate is also falling. 

Hence, depending on the intended holding time, the discounting rate also falls.

Please note, the bigger will be the discounting rate, smaller will be the intrinsic value. 

What is the effect of smaller intrinsic value? We will see it in the conclusion. 

Lets assume that you want to hold this stock for 3 years. Means, the discounting rate that should be used is @7.15% p.a.

What is the DCF formula?

PV = CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+r)^3 + CF4/(1+r)^4 + CF5/(1+r)^5 + Terminal Value

Terminal Value = CFn * (1+3%) / (r-3%)

What is 3% = FCF growth assumed after 5th year onwards.

PV = 1/(1+0.0715) + 1.1/(1+0.0715)^2 + 1.2/(1+0.0715)^3 + 1.35/(1+0.0715)^4 + 1.45/(1+0.0715)^5 + 18 * (1+0.03)/(0.0715-0.03) 

PV = Rs.450 Cr. = Intrinsic Value.

If the current market cap of this stock is say Rs.430 Crore, it means the stock is undervalued (Market cap < Intrinsic value).

Present value (Intrinsic value) calculated for other discounting rates…

Years13710
FD Interest7.25%7.15%7.00%6.85%
PV (Rs. Cr.)440450468486

Read more about best stocks and their intrinsic value estimation

Conclusion…

Which are the most evident inferences of the above intrinsic valuation calculation? Two things:

First, if net of all future cash flows are positive, present value will also be positive. 

But it the net of all future cash flows are negative, present value will also be negative (or zero). 

Second, the higher will be the discounted rate lower will be the present value (intrinsic value). 

Lower intrinsic value means, there will be less chance that stocks will come out as undervalued.

Case: Negative free cash flow…

What happens if free cash flow of a company is negative in initial years?

Which companies will show such characteristics? 

Startups, or companies operating in a sector facing problems. 

So, does negative cash flows make this company bad? Yes and No.

Yes, because all negative cash flow means intrinsic value is zero. 

No, because in case the company has probability of making positive free cash flow at some point of time in future., its intrinsic value will come out positive. 

But such companies for sure will find it harder to gain a tag of “undervalued stock”. 

Consider this example:

CF1 = -10 Cr., CF2 = -12 Cr., CF3 = -8 Cr., CF4 = +18 Cr..

In the initial 3 years, the company has negative FCF. But after fourth year, its cash flow becomes positive. 

What will be the PV (intrinsic value) of this company @7.15% discounting rate?

PV = -10/(1+0.0715)^1 + -12/(1+0.0715)^2 + -8/(1+0.0715)^3 + 18*(1+0.03)/(0.0715-0.03)

PV = Rs.420 Crore = Intrinsic Value

What we can understand from this?

Though in the initial years, the free cash flow was negative, but as cash flow became positive after the 3rd year, intrinsic value still comes out in positive. 

It means, initial few years of negative cash flow does not harms the company a lot.

Yes, but to build on to a higher intrinsic value from zero, company eventually must start generating consistent positive free cash flows at some point in time in future.

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