Learn Fundamental Analysis: Discounted Cash Flow (DCF) Analysis (Part-II)
The Free Cash Flow (FCF)
The cash flow that is essential for DCF Analysis is known as the “Free Cash Flow (FCF)” of the company. FCF represents the surplus operating cash that the company generates after considering capital expenditures, such as investments in land, buildings, and equipment. This surplus cash is what remains for the shareholders after all expenses, including investments, have been accounted for.
When a company has consistent free cash flows, it indicates a healthy financial position. Investors often seek out companies with undervalued share prices and high or increasing free cash flow, believing that the share price disparity will eventually disappear as the share price rises.
Thus, it’s crucial to consider the Free Cash Flow alongside the earnings to assess a company’s true financial health as an investor. FCF for any company can be easily calculated by referring to the cash flow statement, using the formula:
FCF = Cash from Operating Activities — Capital Expenditures
Let’s look at an example of an imaginary company’s last 3 financial years cash flow statements.
You might now have a valid question in mind — if the goal is to calculate the future free cash flow, why do we compute the historical free cash flow? The reason is straightforward: when working with the DCF model, we require predictions of the future free cash flow. The most effective method to predict future free cash flow is by estimating the average historical free cash flow and then incrementally increasing the free cash flow at a certain rate.
Determining the rate at which we grow the free cash flow is the next crucial consideration. I suggest assuming a conservative growth rate. I prefer estimating the FCF for a minimum of 10 years. I achieve this by increasing the cash flow at a certain rate for the initial 5 years, followed by a lower rate for the subsequent 5 years. If you are getting a little confused here, I would encourage you to go through the following step-by-step calculation for better clarity.
Step 1: Calculate the average free cash flow (for the last 3 years)
= 269.11 + 353.99 + (79.55) / 3
= Rs. 181.18 Crores
We are taking the average cash flow for the last 3 years because we are averaging out extreme cash flow and also accounting for the cyclical nature of the business.
Step 2: Determine the growth rate
Choose a rate that you consider reasonable. This rate is the one at which the average cash flow is expected to grow in the future. I typically choose to increase the FCF in two stages. The first stage covers the initial 5 years, and the second stage covers the subsequent 5 years. For a mature company of considerable size, such as a large-cap company, I would recommend using a growth rate of 15% for the first stage and 10% for the second stage. The objective here is to maintain a conservative approach.
Step 3: Estimate the future cash flow
We know the average cash flow for 2022–23 is Rs.181.18 Crores. At 15% growth, the cash flow for the year 2023–24 is estimated to be
= 181.18 * (1+15%)
= Rs. 208.36 Crores
Based on these calculations, let's estimate the future cash flow for 10 years.
With this, we now have a fair estimate of the future free cash flow. How reliable are these numbers you may ask. After all, predicting the free cash flow implies we are predicting the sales, expenses, business cycles, and every aspect of the business. Well, the estimate of the future cash flow is just that, it is an estimate. The trick here is to be as conservative as possible while assuming the free cash flow growth rate. We have assumed 15% and 10% growth rates for the future, these are fairly conservative growth rate numbers for a well-managed and growing company.
The Terminal Value
We have attempted to forecast the future free cash flow for up to 10 years. But what happens to the company after the 10th year? Does it cease to exist? The answer is no. A company is expected to be a ‘going concern,’ which means it continues to exist forever. Consequently, as long as the company operates, it generates some amount of free cash flow. However, as companies mature, the rate at which free cash is generated starts to decline.
The rate at which the free cash flow grows beyond 10 years is known as the “Terminal Growth Rate.” Typically, the terminal growth rate is considered to be less than 5%. I prefer to set this rate between 3–4%, and never beyond that. The “Terminal Value” is the sum of all the future free cash flows beyond the 10th year, also known as the terminal year. To calculate the terminal value, we take the cash flow of the 10th year and grow it at the terminal growth rate. However, the formula for this calculation is different as we are essentially computing the value to infinity.
Terminal Value = FCF * (1 + Terminal Growth Rate) / (Discount Rate — Terminal growth rate)
Please note that the FCF used in the terminal value calculation is that of the 10th year. Let’s compute the terminal value for a company considering a discount rate of 9% and a terminal growth rate of 3.5%:
= 586.91 * (1+3.5%)/(9%-3.5%)
= 11044.57
The Net Present Value (NPV)
We have the future free cash flow for the next 10 years and the terminal value (which represents the future free cash flow of the company beyond the 10th year, up to infinity). Now, we need to determine the value of these cash flows in today’s terms. As you may recall, this involves calculating the present value. Once we have the present value, we can sum these values to estimate the net present value (NPV) of the company.
Assuming a discount rate of 9%, the present value would be:
In addition, we also need to calculate the net present value for the terminal value. To do this, we simply discount the terminal value by the discount rate.
= 11044.57/(1+9%)¹⁰
= 4665.34
Thus, the sum of the present values of the cash flows = NPV of future free cash flows + PV of the terminal value.
= 2284.20 + 4665.34
= Rs. 6949.54 Crores
This implies that, as of today and projecting into the future, the company is expected to generate a total free cash flow of Rs. 6078.83 Crores, all of which would belong to the shareholders of the company.
The Share Price
We have now reached the final step of the DCF analysis. We will calculate the share price of the company based on its projected future free cash flow. With the total free cash flow that the company is expected to generate and the number of shares outstanding (as reported in the annual report), we can calculate the share price by dividing the total free cash flow.
Before doing that, we need to calculate the value of ‘Net Debt’ from the company’s balance sheet. Net debt is calculated by subtracting the current year's total debt from the current year's cash and cash balance.
Net Debt = Current Year Total Debt — Cash & Cash Balance
Let’s assume the total debt is Rs. 75.94 Crores and the Cash & Cash Balance is Rs. 294.5 Crores.
Therefore, the Net Debt is Rs. 218.6 Crores.
A negative sign in this context indicates that the company has more cash than debt. This amount naturally has to be added to the total present value of free cash flows.
= Rs. 6949.54 Crs — (Rs. 218.6 Crs)
= Rs. 7168.14 Crs
Dividing the above number by the total number of shares should provide us with the share price of the company, also referred to as the intrinsic value of the company.
Share Price = Total Present Value of Free Cash flow / Total Number of shares
Let’s assume the total number of outstanding shares is 17.081 Crores. Therefore, the intrinsic value, or the per-share value, is calculated as:
= Rs. 7168.14 Crs / 17.081 Crs
~ Rs. 419 per share
This is the final output of the DCF model.
Modeling Error & the Intrinsic Value Band
The DCF model, although quite scientific, is built upon a series of assumptions. Making assumptions, particularly in finance, is somewhat of an art form. You improve at it as you progress and gain more experience. Therefore, for practical purposes, it is advisable to assume that we might have made a few errors while calculating the intrinsic value, and therefore, we should account for modeling errors.
Allowing leeway for modeling errors enables us to be flexible with the calculation of the per-share value. I prefer to add +10% as an upper band and -10% as the lower band for the perceived intrinsic value of the stock. Applying this to our calculation:
Lower intrinsic value = 419 * (1- 10%) = Rs. 377
Upper intrinsic value = 419 * (1+10%) = Rs.461
Therefore, rather than assuming Rs.419 as the fair value of the stock, I would consider the stock to be fairly valued between 377 and 461. This range would represent the intrinsic value band.
Based on the calculated intrinsic value band, we can assess the market value of the stock:
- If the stock price is below the lower intrinsic value band, the stock is considered undervalued, making it a potential buy.
- If the stock price falls within the intrinsic value band, the stock is deemed fairly valued. Holding on to the stock is advisable while refraining from adding to the existing position.
- If the stock price exceeds the upper intrinsic value band, the stock is regarded as overvalued. Investors may choose to either secure profits or maintain their current holdings, but it’s not recommended to make fresh purchases at these levels.
Conclusion
Equity research involves a comprehensive examination of a company from three different angles or stages. The initial stage (stage 1) primarily involves qualitative analysis of the company. During this stage, we delve into the who, what, when, how, and why of the company. I believe this stage is extremely crucial. If any aspect seems unconvincing, I refrain from proceeding further. It’s essential to remember that the market is full of opportunities, and it’s important not to force yourself into committing to an opportunity that doesn’t resonate with you. I move on to stage 2 only when I am fully confident with my findings in stage 1.
During stage 2, the key focus is to use a standardized checklist for assessing the company’s performance. The checklist I have presented is my version and I suggest you develop your own, ensuring each item is backed by a solid rationale.
Once the company clears both stages 1 and 2 of equity research, I move on to stage 3. Here, I evaluate the intrinsic value of the stock and compare it with the market value. If the stock is trading below its intrinsic value, it is considered a favorable purchase. Otherwise, it is not. When all three stages align to your satisfaction, you can feel confident in owning the stock. Once you make the purchase, it’s important to stay invested, ignore daily market volatility, and let the market take its course.
Limitations of DCF Analysis
In this final section, we will explore several crucial factors that can greatly influence your investment choices. Having delved into the Discounted Cash Flow (DCF) analysis for intrinsic value calculation in the previous chapter, it’s important to recognize that while the DCF method is a reliable tool, it also comes with its own set of limitations. The accuracy of the DCF model heavily relies on the accuracy of the assumptions fed into it. Incorrect assumptions can lead to skewed fair value and stock price computations.
- Forecasting Requirements: The DCF model necessitates accurate predictions of future cash flows and business cycles, posing a challenge for both fundamental analysts and company management.
- Sensitivity to Terminal Growth Rate: The DCF model is highly sensitive to the terminal growth rate, meaning even a small change can significantly impact the final output, such as the per-share value.
- Ongoing Adjustments: Continuous updates are necessary for the DCF model to align with new data, both quarterly and yearly, which entails regular modifications to inputs and assumptions.
- Long-Term Focus: DCF analysis is geared toward long-term investments, offering little to investors with short-term perspectives (i.e., a 1-year investment horizon).
Additionally, the DCF model’s rigid parameters might cause you to overlook exceptional opportunities, further adding to its limitations. To mitigate these limitations, it is essential to maintain a conservative approach when formulating assumptions. Here are some guidelines for incorporating conservative assumptions:
- Keep the FCF (Free Cash Flow) growth rate moderate, usually around 20%. While exceptions might apply to young companies in high-growth sectors, a rate exceeding 20% is generally not recommended.
- Strike a balance between an extended timeframe and potential inaccuracies when determining the duration of the DCF analysis. A common practice is to opt for a 10-year 2-stage DCF approach.
- Employ a 2-stage DCF valuation to enhance analysis accuracy. During the first stage, project FCF growth at a specified rate, and in the second stage, use a more conservative growth rate compared to the first stage.
- Maintain a low terminal growth rate to minimize sensitivity in the DCF model. It is advisable to keep the terminal growth rate around 4% and avoid surpassing this threshold.
Margin of Saftey
Certainly! Benjamin Graham emphasized the importance of the “margin of safety” in his renowned work “The Intelligent Investor.” This concept advises investors to purchase stocks only when they are trading at a price below the estimated intrinsic value. While adhering to the margin of safety does not guarantee successful investments, it does provide a cushion against potential errors in calculations.
So, considering an intrinsic value of Rs.419/- per share with a 10% modeling error, the lower intrinsic value estimate is Rs.377/-, accounting for potential errors. The Margin of Safety principle suggests an additional discount of at least 30% from the intrinsic value, enhancing the protective cushion for the investment.
Indeed, adding an extra discount to the intrinsic value might appear overly conservative. However, it acts as a safeguard against potential inaccuracies and unfortunate market events. By applying this approach, a stock that seems appealing at Rs.100 becomes an even more attractive opportunity at Rs.70, aligning with the principles followed by savvy value investors.
Considering the additional 30% discount for the margin of safety, the intrinsic value of the stock would be approximately Rs.263. Therefore, I would confidently consider purchasing this stock if it were priced at Rs.263, aligning with the margin of safety principle.
Certainly, when high-quality stocks significantly drop below their intrinsic value, they tend to attract attention from value investors. Therefore, when the margin of safety principle is applicable, it’s advisable to seize the opportunity as soon as possible. As a long-term investor, such favorable deals, like a quality stock trading below its intrinsic value, should not be overlooked. Additionally, it’s crucial to note that good stocks are often available at substantial discounts, especially during bear markets, when market sentiment is extremely pessimistic. Consequently, it’s essential to maintain sufficient cash reserves during bear markets to capitalize on such opportunities.
