Share market is a place where one can sell you a one-liter packet of milk for Rs 1,000 and if you might be even happy to purchase that. It’s completely impossible to decide whether a stock is overvalued or undervalued just by looking at the market price of the company.
And that’s why valuation is a crucial factor while deciding whether to invest in a stock or not. You do not want to purchase a stock at ten times its valuation. After all, a good company may not be a good investment if you are overpaying for it. It’s always preferable to invest in stocks when they are trading below their true (intrinsic) value.
In the words of the legendary investor Warren Buffett, the intrinsic value of a company can be defined as —
“The intrinsic value of a company is the discounted value of the cash that can be taken out of a business during its remaining life.” — Warren Buffett
Nevertheless, evaluating the value of a company using this definition is easier said than done. After all, finding the intrinsic value of a stock requires forecasting the future cash flows of a company which needs a lot of calculated assumptions like growth rate, discount rate, terminal value etc.
Anyways, one of the most popular approaches to find the intrinsic value of a company is the discounted cash flow (DCF) analysis. In this post, we are going to discuss the step-by-step explanation of how to find the true value of a stock using the DCF method. Further, we’ll also perform the DCF analysis on a real-life company listed in the Indian stock market to find its true value.
Quick note: I’ll try to keep the explanation as simple as possible so that you can easily understand the fundamentals. Let’s get started.
Discounted cash flow valuation:
Before we start the actual calculations, let’s quickly discuss what exactly is discounted cash flow analysis.
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.
DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. (Source: Discounted Cash Flow (DCF)– Investopedia)
In other words, discounted cash flow analysis forecasts the future cash flow of a company and later discounts them back to their present value to find the true intrinsic value of the stock (at the time of calculation).
Further, I would also like to mention that valuing stocks using the DCF method requires a little knowledge of a few common financial terms like free cash flow, discount rate, growth rate, outstanding shares etc. Here is a quick walk through the key inputs required in the discounted cash flow analysis.
Key inputs of Discounted Cashflow Valuation:
1. Free cash flow (FCF): Free cash flow can be defined as the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings. Free cash flow of a company can be calculated by using the below formula:
FCF = Cash flow from operating activities — capital expenditures
2. Growth Rate: It is the expected rate at which the company may grow in the upcoming 5–10 years. It’s really important to use a realistic growth rate for efficient calculations. Else, the calculated intrinsic value might be misleading.
Different investors use different approaches to find the expected growth rate of a company. Few of the common ways are by looking at the historical growth rate for the earnings/profits, reading the analysts reports to find out what they are forecasting, peeking in the company’s annual report/latest news to find out what the management/CEO is saying regarding the company’s growth rate in upcoming years etc.
Quick Note: In the book- ‘The little book of valuation‘, the author Aswath Damodaran has used an interesting method to find the growth rate of a firm. He argues that for a firm to grow, it has to either manage its assets better (efficiency growth) or make new investments (new investment growth). He used the multiple of proportion invested and return on investment to arrive at the growth rate in earnings. If you haven’t read his book, it is a good place for the beginners to start learning valuation of stocks.
3. Discount rate: The discount rate is usually calculated by CAPM (Capital asset pricing model). However, you can also use the discount rate as the rate of return that they want to earn from the stock. For example, let’s say that you want an annual return rate of 12%, then you can use it as the discount rate.
As a thumb rule for the discount rate, use a higher value if the stock is riskier and a lower discount rate if the stock is safer (like blue chips). This rule is in accordance with the principle of the risk-reward which claims a higher reward for a higher risk.
4. Terminal Multiple Factor: This is the fourth input of the DCF calculation that is used to find the terminal value of the company. Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the DCF model as it typically makes up a large percentage of the total value of a business.
There are two approaches to the terminal value formula: (1) perpetual growth, and (2) exit multiple.
In this post, we are going to use the exit multiple approach. This approach is more common among industry professionals as they prefer to compare the value of a business to something they can observe in the market. The most commonly used terminal factor is EV / EBITDA. (Read more here).
Steps to value stocks using DCF Analysis:
Here are the steps required to value stocks using the discounted cash flow valuation method:
- First, take the average of the last three years free cash flow (FCF) of the company.
- Next, multiply this calculated FCF with the expected growth rate to estimate the free cash flows of future years.
- Then, calculate the net present value of this cash flow by dividing it by the discount factor.
- Repeat the same process for the next 10 years to find the net present value (NPV) of the future free cash flows. Add the NPV’s of the FCF for all the ten years.
- Next, find the terminal value the stock by multiplying the final year FCF with a terminal multiple factor.
- Add the values from step 4 and 5 and adjust the total cash and debt (mentioned in the balance sheet of the company) to arrive at the market value for the entire company.
- Finally, divide the calculated number in step 6 by the total number of outstanding shares to arrive at the intrinsic value per share of the company.
If the final intrinsic value of the company is lower than the current market price of the share, then it can be considered undervalued (and a good time to invest in that stock assuming the quality of the stock is also amazing).
On the other hand, if the final intrinsic value of the company is greater than the current market value, then the stock might be over-valued. In such a scenario, it’s better to keep that stock in the watchlist and wait for the price to come down within the purchase range.
That’s all. This is the exact approach used to find the discounted cash flow value of any company.
In any case, if you are not comfortable in performing DCF valuation using excel sheets, you can also use the Trade Brains’ online DCF calculator to find the intrinsic value of a stock.
Real life example of valuing stocks from Indian stock market using DCF analysis.
Now, let’s calculate the Intrinsic value of Ashok Leyland (NSE: ASHOKLEY) using the Discounted Cashflow Valuation method. (Please note that all the data used here has been gathered from Annual reports.)
- First, we will start by finding the free cash flow of Ashok Leyland. Here, we’ll take the FCF for the last 3 years and consider their average as a reasonable FCF. Now, free cash flow is equal to cash from operating activates minus the capital expenditures. The average FCF for the last three years turns out to be Rs 1715 Cr.
- Next, we’ll project this FCF only for the upcoming ten years. Although, the company may continue for many more years after the tenth year, however predicting free cash flow for over 10 years is really difficult. Therefore, we assume that the company will sell off all its assets at the end of year ten at a ‘Sell off valuation’ (Terminal value). We’ll use a multiplier of 9 for the tenth year cash flow to simulate the value of these cash flows in the case company would sell all its assets (This is a necessary assumption that we need to make in order to find the value of the company).
- Apart from the cash flows, the next important input is cash and cash equivalents which the company reflects on its balance sheet. For Ashok Leyland, this value is equal to Rs 993 Cr.
- Besides cash, the next essential input is the debt (as debts have to be first paid off and shareholders are last in the line). Ashok Leyland has a total debt of Rs 515 Cr.
- Next, we need to find the annual growth rate for Ashok Leyland. From the historical reports, we’ll consider a conservative growth rate of 12.75% per annum for our calculations of forecasted cash-flow.
- Further, here we are considering a discount rate of 13.5% for discounting the future cash flows to their present value.
- In addition, we need the total numbers of outstanding shares of Ashok Leyland. It is equal to 294 Crores.
- Finally, let’s take a margin of safety of 10% on the overall calculated intrinsic value to give our calculations a benefit of doubt. (Higher the margin of safety, lower is the risk).
After placing the above values in the online DCF Calculator, the intrinsic value per share of Ashok Leyland turns out to be Rs 93.19 (after a margin of safety of 10% on the final intrinsic price). This is the true value estimate per share for Ashok Leyland at the time of writing using the DCF model.
The current stock price of Ashok Leyland is at Rs 105.55. This means that this stock is currently slightly overvalued compared to the calculated intrinsic price.
Quick Note: This intrinsic value is based on my calculations and assumptions. Although I’ve tried to be reasonably conservative in using the inputs, still no valuation should be considered precise as there is no guarantee that the company will grow at the assumed growth rate for the upcoming years. The key while performing DCF is to always consider rational inputs to arrive at a roughly correct intrinsic value.
Warning: Garbage in, Garbage out
Now that you have understood how to value stocks using the DCF analysis approach, let me give you a FAIR WARNING. DCF is a very powerful tool for valuing stocks. However, this methodology is only as good as the inputs.
For example, even a small change in inputs (like growth rate or discount rate) can bring large changes in the estimated value of the company. (Try changing these values by 1% or 2% and you can notice a significant change in the result). In short, if the inputs are not reasonable, the out will also not be correct -’Garbage in, garbage out’.
Therefore, fill all the inputs carefully as they all have the potential to erode the accuracy in the estimated intrinsic value.
DCF method is a very powerful method of valuing stocks. However, this method requires rational inputs.
Many investors who have already made up their mind to purchase a stock, can easily infiltrate the final result by assuming a higher growth rate/ terminal value or a lower discount rate. However, if you are choosing wrong or unrealistic inputs for growth rate, discount rate etc, the final intrinsic value per share may also be incorrect. Therefore, it is always recommended to use conservative inputs while performing DCF valuation.
That’s all for this post. I hope it is useful to you. If you have any questions, feel free to comment below. Happy Investing.
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