Valuing a Business for Stock Investing

It is important for stock investors to learn to value a business. Valuing a business is one of the most important skill that all stock investors must know. Without knowing how to value a business, stock investing becomes more like gambling. Not many people care to learn about valuing a business. But before buying a stock, genuine investor must value its underlying business. Suppose one wants to buy stocks of APPLE INC, it is essential to first calculate intrinsic value of the company (business). One can also use our online intrinsic value calculator to estimate intrinsic value of business/stocks.

On one side business valuation requires effort hence people ignore it. On other side stock trading can be done in fraction of seconds. This feeds the temptation to buy stocks without full knowledge about it. It is not easy to delay this temptation stock. But stock investing cannot be followed on basis of temptations and feelings.

Stock investing is more mathematics than psychology. Even best of stocks, if not bought at right price will be a loss making purchase. Valuing a business helps people to buy stock at right price.

Valuing a business = sum of ‘present value’ of ‘ALL future cash flows’

Valuing a business means calculating its true value. True value of business means what? Depending on future income generating prospects of a business, investors can value a business. More accurately one can predict future income, closer will be the estimate to its ‘true value’. Market capitalization is a true value?

Market capitalization of a stock represents ‘market value’ of business. But this may not necessarily represent true value of business. For investors it is essential to compare ‘true value’ with ‘market value’ (capitalization). To estimate true value of business, one must first calculate ‘all future cash flows’. Once all future cash flows are known, we must discount it to ‘present value’. Suppose a companies estimated future cash flows are $1 million (1st year), $1.2 million (2nd year), $1.3 million (3rd year), $1.5 million (4th year) & $5.5 million (5th year & beyond). To value a business, add all future cash flows. But before we add up all future cash flows we must discount it to present value. Suppose, after discounting, present value of future cash flows are: $0.92 million (1st year), $1.01 million (2nd year), $1.00 million (3rd year), $1.06 (4th year) & $3.57 million (5th year & beyond). True value of business will be sum of all future cash flows: $(0.92+1.01+1.00+1.06+3.57) = $7.57 million.

[To know more about discounting rate, see WACC explained below]



Valuing A Business



Future Cash Flow = Free Cash Flow of Next 5 Years & Beyond

Free cash flow one of the most important factor to estimate true value of business. The accurately one can calculate the ‘free cash flow’ more precise with be the estimated true value. Free cash flow is not same as PAT (Profit after tax). Free cash flow is that available free cash that is available for business owners.

Business owners use this ‘available free cash’ to enhance shareholders value. Shareholders values can be enhanced by increasing companies EPS or by distributing dividends. To improve EPS, company can do two things. It can either buy-back its stocks or it can increase PAT. When company will buy-back its shares? Company will only buy-back its shares when it thinks that present market price is less than its true value. Means stock is trading at undervalued price levels. But this does not happen very often. Alternatively, companies increase their PAT by expanding or modernizing its facility. Expansion and modernization projects are executed in company by planning CAPEX. Formula for calculating free cash flow is as below:

Free Cash Flow = Revenue – (Operating Expense + Net Investment + Increase in Working Capital)

Net Investment = CAPEX – Depreciation

(CAPEX – Depreciation) = (Gross Block – Depreciation) Year 2 – (Gross Block – Depreciation) Year 1

(CAPEX – Depreciation) = (Net Block) Year 2 – (Net Block) Year 1
[Values of Gross Block & Net Block is available in moneycontrol.com for Indian Investors]

Increase in Working Capital = (Curr. Asset – Curr. Liability) Year 2 – (Curr. Asset – Curr .Liability) Year

Valuing A Business

Discounting Rate = Weighted Average Cost of Capital (WACC)

Discounting rate is required to calculate present value. It is a very important parameter to estimate companies ‘true value’ correctly. Estimating discounting rate is simple. By looking at companies financial reports one can calculate WACC. The calculated WACC can be used to discount future cash flows.

Company needs capital to run its business. The company generates capital in two ways: By Equity & Debt. Both equity and debt financers expect returns from the company. Suppose a company generates its capital equally from debt and equity source. Suppose the debt financer expects 8% returns, and equity finance (shareholder) expects 16% per annum returns. Average returns that company must pay to its financers is 12% [(15%+8%)/2]. WACC for this company will be 12% per annum. Every year, the company must pay 12% returns to their financers. This return will be required to paid from companies operating profits. WACC is considered as a very reliable discounting by expert investors.

WACC = E/(E+D) * COE + D/(E+D) * COD

E = Shareholders Equity (Balance Sheet)

D = Total Debt

R = Risk Free Rate (Yield of 10Y Govt. Bond) %

B = Stock Beta (Available in Reuters.com)

RP = Risk Premium (Expected Return Above Risk Free Rate) %

T = Corporate Tax Rate %

COE = Cost of Equity = R + B*RP

COD = (R+1) * (1-T)

Present Value = Discounted Future Value

Why to calculate present value? $500 received today is worth more than $500 received after 3 years. Suppose one receives $500 today. If this $500 is invested in bank deposit @ 8% interest, after three years it will be worth $625. It means after 3 years same $500 is worth much more. Receiving $500 today gives us opportunity to make it grow.

To value a business realistically it is essential to use the concept of ‘present value’. All future cash flows must be discounted to their present value. Suppose a company generates $100 every year till next 10 years. Without calculating present value, the company will be valued at $100×10 = $1,000. But we know that $100 received after 10 years from now will be valued much lesser. Considering a uniform discounting rate of 9% p.a. Company valuation will look like this:

Valuing A Business

Year Future Value (FV) Present Value (PV) Company Valuation (Sum of all PV’s)
1 $100 $92.59 $92.59
2 $100 $85.73 $85.73
3 $100 $79.38 $79.38
4 $100 $73.50 $73.50
5 $100 $68.06 $68.06
6 $100 $63.02 $63.02
7 $100 $58.35 $58.35
8 $100 $54.03 $54.03
9 $100 $50.02 $50.02
10 $100 $46.32 $46.32
  $1000   $671.00

Final Words….

In the process of valuing a business, one must first estimate ‘all future free cash flows’ of a business. It is comparatively easier to predict next 5 years cash flows. But beyond 5 years it is difficult. This is the reason why beyond 5 years, it is not useful to calculate free cash flow. Instead, one can calculate ‘terminal value’. Terminal value is an estimate of ALL possible free cash flow to happen beyond the fifth year. Formula for terminal value (TV) will be:

TV = FCF5 * (1 + G) / (WACC – G)

G = Expected Growth rate beyond 5th year

FCF5 = Free Cash Flow of 5th Year

So, estimating 5 years of free cash flow and one terminal value gives ALL cash flows for a company. Once we have all the cash flows, we must mathematically calculate present value of all of it. Sum of present value of cash flows will give us the true value of a company.

Current Valuations of Top Businesses of India

(Updated as on Sep’2015. & as reported on Mar’2015)

Valuing Business in India

Tata Consultancy Services (TCS) – Overvalued

Market Valuation (Market Cap) of TCS is 5,053,518 MN INR. True valuation of business of TCS is 5,649,032 MN INR.

True valuation of business applying margin of safety is 3,766,021 MN INR. True value (Intrinsic Value) of TCS is Rs 2,884 per share. Applying Margin of safety, right price at which one can buy TCS is Rs 1,922 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of TCS is Rs 2,580 per share. Current Revenue of TCS is 946,484 MN INR. On an average, in last 5 years, the company has spent CAPEX of 26,800 MN INR. Present market value of Equity of TCS is 517,625 MN INR. Present market value of Debt of TCS is 5.8 MN INR. On an average, free cash flow growth of TCS expected in next 5 years will be 25% per annum. Terminal growth expected beyond 5th year is 3% per annum.

Reliance Industries Ltd. (RIL) – Negative Valuation

Market Valuation (Market Cap) of RIL is 2,772,985 MN INR. True valuation of business of RIL is -1,020,706 MN INR. True valuation of business applying margin of safety is -680,471 MN INR.

True value (Intrinsic Value) of RIL is Rs -315 per share. Applying Margin of safety, right price at which one can buy RIL is Rs -210 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of RIL is Rs 857 per share. Current Revenue of RIL is 3,754,350 MN INR. On an average, in last 5 years, the company has spent CAPEX of 426,394 MN INR. Present market value of Equity of RIL is 2,184,990 MN INR. Present market value of Debt of RIL is 1,207,680 MN INR. On an average, free cash flow growth of RIL expected in next 5 years will be -24% per annum. Terminal growth expected beyond 5th year is 3% per annum.

ITC – Overvalued

Market Valuation (Market Cap) of ITC is 2,605,044 MN INR. True valuation of business of ITC is 650,401 MN INR. True valuation of business applying margin of safety is 433,601 MN INR.

True value (Intrinsic Value) of ITC is Rs 81 per share. Applying Margin of safety, right price at which one can buy ITC is Rs 54.10 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of ITC is Rs 325 per share. Current Revenue of ITC is 388,348 MN INR. On an average, in last 5 years, the company has spent CAPEX of 28,248 MN INR. Present market value of Equity of ITC is 317,354 MN INR. Present market value of Debt of ITC is 607 MN INR. On an average, free cash flow growth of ITC expected in next 5 years will be 13% per annum. Terminal growth expected beyond 5th year is 3% per annum.

INFOSYS – Overvalued

Market Valuation (Market Cap) of INFOSYS is 1,257,577 MN INR. True valuation of business of INFOSYS is 13,154 MN INR. True valuation of business applying margin of safety is 8,769 MN INR.

True value (Intrinsic Value) of INFOSYS is Rs 11.45 per share. Applying Margin of safety, right price at which one can buy INFOSYS is Rs 7.64 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of INFOSYS is Rs 1095 per share. Current Revenue of INFOSYS is 8,711 MN INR. On an average, in last 5 years, the company has spent CAPEX of 375 MN INR. Present market value of Equity of INFOSYS is 8,762 MN INR. Present market value of Debt of INFOSYS is 0 MN INR. On an average, free cash flow growth of INFOSYS expected in next 5 years will be 3.84% per annum. Terminal growth expected beyond 5th year is 3% per annum.

Coal India Ltd. (CIL) – Overvalued

Market Valuation (Market Cap) of CIL is 2,311,789 MN INR. True valuation of business of CIL is 362,899 MN INR. True valuation of business applying margin of safety is 241,933 MN INR.

True value (Intrinsic Value) of CIL is Rs 57.5 per share. Applying Margin of safety, right price at which one can buy CIL is Rs 38 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of CIL is Rs 366 per share. Current Revenue of CIL is 719,268 MN INR. On an average, in last 5 years, the company has spent CAPEX of 37,202 MN INR. Present market value of Equity of CIL is 404,189 MN INR. Present market value of Debt of CIL is 2,018.3 MN INR. On an average, free cash flow growth of CIL expected in next 5 years will be -4% per annum. Terminal growth expected beyond 5th year is 3% per annum.

SUN PHARMA – Slightly overvalued

Market Valuation (Market Cap) of SUN PHARMA is 18,66,119 MN INR. True valuation of business of SUN PHARMA is 2,862,375 MN INR. True valuation of business applying margin of safety is 1,908.250 MN INR.

True value (Intrinsic Value) of SUN PHARMA is Rs 1,382 per share. Applying Margin of safety, right price at which one can buy SUN PHARMA is Rs 921 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of SUN PHARMA is Rs 901 per share. Current Revenue of SUN PHARMA is 272,865 MN INR. On an average, in last 5 years, the company has spent CAPEX of 7,298 MN INR. Present market value of Equity of SUN PHARMA is 293,582 MN INR. Present market value of Debt of SUN PHARMA is 13,684 MN INR. On an average, free cash flow growth of SUN PHARMA expected in next 5 years will be 49% per annum. Terminal growth expected beyond 5th year is 3% per annum.

ONGC – Negatively Valued

Market Valuation (Market Cap) of ONGC is 2,001,985 MN INR. True valuation of business of ONGC is -1.179.157 MN INR. True valuation of business applying margin of safety is -786,105 MN INR.

True value (Intrinsic Value) of ONGC is Rs -137.82 per share. Applying Margin of safety, right price at which one can buy ONGC is Rs -92 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of ONGC is Rs 234 per share. Current Revenue of ONGC is 1,608,897 MN INR. On an average, in last 5 years, the company has spent CAPEX of 463,087 MN INR. Present market value of Equity of ONGC is 18,29,275 MN INR. Present market value of Debt of ONGC is 471,589 MN INR. On an average, free cash flow growth of ONGC expected in next 5 years will be -9% per annum. Terminal growth expected beyond 5th year is 3% per annum.

Hindustan Unilever Ltd (HUL) – Overvalued

Market Valuation (Market Cap) of HUL is 1,800,003 MN INR. True valuation of business of HUL is -282,845 MN INR. True valuation of business applying margin of safety is 188,564 MN INR.

True value (Intrinsic Value) of HUL is Rs 1301 per share. Applying Margin of safety, right price at which one can buy HUL is Rs 88 per share. At this price expected return (CAGR) is 15% per annum if held for long term. Current market price of HUL is Rs 832 per share. Current Revenue of HUL is 319,721 MN INR. On an average, in last 5 years, the company has spent CAPEX of 4,835 MN INR. Present market value of Equity of HUL is 40,464 MN INR. Present market value of Debt of HUL is 70 MN INR. On an average, free cash flow growth of HUL expected in next 5 years will be 0.45% per annum. Terminal growth expected beyond 5th year is 3% per annum.


Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

4 Comments on "Valuing a Business for Stock Investing"

  1. Just superb information for everyone.
    Thank u sir

  2. Incredibly useful information, thank you

  3. Awesome post. Thanks for sharing this!

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