Discounted cash flow model (DCF) is an excellent method of stock valuation. Nearly all analysts rely on DCF model to estimate intrinsic value of stocks.
What makes discounted cash flow (DCF) model reliable? It is its approach towards estimation of intrinsic value. The ‘concept’ that is used to analyze stocks in DCF model is ‘free cash flow’. The concept of future cash flows makes the estimation by DCF model very reliable.
Free cash flow (FCF) is that available cash that companies uses to expand their business. Free cash flow is like ‘extra cash’ which is used to improves ‘shareholders value’. Typically, good companies uses its FCF to do the following:
– To increase revenue
– To improve efficiency of operations
– To reduce cost of operations
– To buy back share from market
– To distribute dividends to its shareholders
– To reduce debt burden
This is the reason why, company which maintains a positive ‘free cash flow’ are valued higher. Implementation of any of the above listed points will improve companies/shareholders earnings. The higher is the FCF better will be the improvements.
Investors must look at past 10 years financial statement of companies to calculate its free cash flow. FCF of last 10 years will help investors to forecast ‘future free cash flow’ of next 5-10 years.
Lets see how we can use the concept of discounted cash flow model of stock valuation for our investment purpose.
Step 1 – Calculate Free Cash Flow of Last 10 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.
Step 2 – What is the trend of Free Cash Flow
While calculating FCF of past 10 years, it is also important to check if the FCF is increasing or decreasing with time. Ideally, if FCF grows with time its considered a good sign.
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.
It is also essential to keep a watch that FCF growth is not be negative. Even when FCF is positive, a negative FCF growth is also not a healthy sign for company.
A company with positive FCF growth will be valued higher compared to a case when its FCF is reducing.
Step 3 – Forecast Future Free Cash Flow (next 10 years)
Once step 1 (calculate FCF of past) and step 2 (FCF trend) is done, one is ready to forecash future FCF. Here an assumption is made that, considering all other conditions remaining same, company is most likely to duplicate its past FCF in future.
A company whish has improved its FCF in last 10 years will continue to do it next 10 years as well.
A company whose FCF has depleted in last 10 years will continue to do the same in next 10 years as well.
A company whose FCF was negative in last 10 years will continue to follow the same trends in next 10 years as well.
A company whose FCF is fluctuating between negative and positive will continue to follow the same trend in next 10 years.
With these assumptions in place, one must forecast the FCF of next 10 years.
Step 4 – Forecast Future Free Cash Flow (beyond 10 years) – Terminal Value (TV)
What we have calculated in step 3 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 inteinsic 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
Note: 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 by giving higher values to (1) risk free rate & (2) risk premium in above indicated formula. My suggestion will be to keep risk free rate below 6% and risk premium below 5%.
Step 5 – Calculated Present Value (PV) of Future FCF & TV calculated above
Future FCF & Terminal Value (TV) calculated in step 3 & 4 above should be suitably discounted to present value. Here it is very important to pick a right discounting factor.
Almost all experts across the globe prefers use of WACC to calculate the discounting factor. [In step 4 we have already explained how to calculate WACC].
One must use the below formula to calculate the discounting factor for each year:
Discount factor = 1 + (WACC+1)^n, (n = 1, 2, 3, 4, 5….etc no of years)
Multiplying the discounting factor with future FCF’s & TV will give us the present value of all future cash flows.
Step 6 – 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 = PV of FCFC + PV of TV as calculated in step 5 above.
Once total value is calculated, one must find the ‘total number of shares outstanding’ in the market. This value is available in companies financial reports. One can also find this data readily available on free websites like moneycontrol.com or economictimes.com etc.
Calculate total value / no of shares outstanding in market.
Step 7 – Compare Intrinsic value per share with market price per share
‘Total value’ per share is called intrinsic value of company. 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. Though many people would like to analyze stocks based on its intrinsic value but due to its complexity of calculation skip this step. To resolve this ambiguity, I have develop a simple stock analysis worksheet to calculate intrinsic value of stocks using DCF model. I will suggest users to use this worksheet to get a feel of how DCF model works. But this worksheet should not be treated as an investment advice. One must use this worksheet with objective to get a feel of how DCF model works.