So you have found a great business with a lot of growth potential, but there is one problem. How much should I pay for it? What’s the right price?
Trust me, it is one question that almost all the investors struggle with. In this post, I am going to discuss how How to Value a stock using Discounted Cash Flow Analysis and find the right buying price.
Valuing a stock in critical for successfully investing in stock market. Among hundreds of valuation approaches, Discounted Cash Flow(DCF) is one of the most reliable, successful and thus, most widely used approach to value any stock. So, in this post of How to value a stock using Discounted Cash Flow analysis, you will learn a step by step process of what is DCF, and how to use it.
What is Discounted Cash Flow(DCF) Model of Valuation?
A Discounted Cash flow(DCF) analysis is an approach of finding the right value or price of a stock which you should pay today to get the returns you expect.
In other words, a Discounted Cash Flow(DCF) analysis is a method used to measure the attractiveness of an investment opportunity.
Discounted Cash Flow(DCF) analysis uses estimated future free cash flows to a business, discounts them to the present value to arrive at an estimated price and evaluate the attractiveness of an investment.
Too many jargon? Okay, let me give you a simple example that will help you understand better.
Example of DCF
Here is a simple example, that will help you understand how to value a stock using discounted cash flow analysis. Let’s say you want to buy a house, you want to rent it in order to make passive income from it.
The question is how much should you pay for it?
Since the house is an investment, you have to make sure that after a certain time period, you are not only able to get your invested capital back from the house, but also make some profit. How would you do that?
In order to ascertain your profits, you have to make three assumptions:
First, How long will you stay invested in this house(your investment horizon)
Second, How much cash you expect to receive from the house over the period of investment?(estimated future cash flows)
Third, How much profit you expect to get out of the investment.(your expected rate of return on investment)
and Fourth, On the basis of the above factors, you have to determine what price you should pay for the house to make a successful investment?
Here is a simple info-graphic that sums up all the assumptions you need to make before proceeding to use Discounted Cash Flow Analysis:
Let’s say, you are going to stay invested in this house for the next 10 years.
You will be able to generate Rs.1,000 as rent every month from the house, which makes it Rs. 12,000per year(1,000*12=12,000).
If you pay Rs. 1,20,00 for the house today, you will get Rs. 1,20,000 back as cash flow over a period of 10 years, (12,000*10=1,20,000)
But does that make a good investment?
I mean, why would you pay an amount today and get the same 10 years later?
The purpose of an investment is to generate profit over time, and if an asset is not generating any profit over the years, it’s not worth your time effort or capital.
To make some money, you need to pay less than the estimated future cash flows. If you pay Rs. 1,00,000 for the house today, you will be able to earn a profit of Rs. 20,000 for 10 years(i.e 20%).
If you pay Rs. 70,000 for the house you will be able to generate a profit of Rs.50,000 over the next decade(i.e almost 72% profit).
Lower you pay better will be the profits.
While analyzing a stock using Discounted Cash Flow Model(DCF) analysis model, you need to follow the same principles.
Why? Look, Every business generates profits in the form of cash flow(which was rent in our previous example).
While using a Discounted Cash Flow(DCF) Analysis, you have to look at the past cash flows(free cash flows, to be specific) of the company, and based on the past performance, you have to make an estimate of expected future cash flows(just like we estimated the total rent for the next 10 years from the house) and discount them back to present value to make a conservative estimate of what price you should pay for each share of the company.
Before we move on to learning how to value a stock using Discounted Cash Flow Analysis, it requires knowledge of few financial terms such as free cash flow, growth rate, discount rate, perpetuity growth rate. Here is a brief introduction of each terms to be used:
Discounted Cash Flow(DCF) Analysis.The Inputs
Total Number of Shares Outstanding: The first input you need is the total number of shares outstanding of the company, you can easily get the number of outstanding shares by dividing total share capital by the face value of each share of the company.
For Example, if a company has share capital of Rs.100 crores and has a face value of Rs. 10 per share, the total number of outstanding shares will be 10 crores (100/10=10). We will use this number to find the fair price of a stock.
Free Cash Flow: Free cash flow is the cash left with the company after paying for all the expenses related to daily operations of the business and any assets bought to expand the business(such as plant and machinery).
Free cash flow is the most important and reliable part of Discounted Cash flow(DCF) analysis because unlike Net Profit and sales, which are prone to accounting manipulation and window dressing, cash flow statements are hard to manipulate.
Free cash flow of the company can be calculated using following formula:
Free Cash Flow = cash flow from operating activities – capital expenditures
Growth Rate: Growth Rate is the the rate at which a company is expected to grow in the future. You have to be very realistic and rational about the growth rate you chose for the company, else the intrinsic value arrived may be misleading.
You can estimate the growth rate of a company by looking at the past earnings growth record or by reading the reports by various analysts and make a consensus growth estimate.
It is usually seen that a small or a midcap company shows higher rate of growth compared to a large cap company.
Depending on these factors, you can make your own growth assumptions and make predictions about future growth of the company.
Discount Rate: Discount rate is the rate at which you would discount the future cash flows of the company to its present value.
Discount rate is usually calculated by using CAPM(Capital Asset Pricing Model) method, which calculates the weighted average of cost of capital of both debt and equity. Since CAPM is complex and time taking, it’s better to use the rate of return you want to earn from the stock.
As a thumb rule it is always advisable to use higher rate of return for high risk stocks, and lower rate of return for safer stocks.
This is in accordance with the rule of risk-reward which claims higher reward for high risk stocks.
Perpetuity Growth Rate: Perpetuity growth rate represents an assumption that a company will continue to grow at a steady constant rate into perpetuity.
Typically, the perpetual growth rate ranges from historical inflation rate to historical GDP growth rate.
There are two different approaches to calculate terminal value 1. Perpetual growth 2. Exit multiple. In this post we will use perpetual growth approach.
Having understood the terms related to DCF analysis, let’s move on and understand the steps of how to value a stock using Discounted Cash Flow Analysis:
Steps to using DCF Analysis
Here are the steps involved to perform Discounted Cash Flow(DCF) analysis:
Step 1: Find three to five years of Free Cash Flow (depending on your investment horizon).You can easily calculate the Free Cash Flow from cash flow statements by subtracting Capital expenses from Operating Cash Flows.
Note:If you don’t want to go through the painful process of calculating free cash flow, you can find the Free Cash Flow data from morningstar.in.
Just go to morningstar.in.
Type the name of the company in the search box that says ”quote”
Click on the financials tab, which will display all the financial data, scroll down and click on all financial data.
Then scroll back up and click on the cash flow tab, at the bottom of the cash flow statement, you will find free cash flow of the company for the past 5 years.
Step 2: Once you have five years of free cash flow data, you need to calculate the Net Present Value of the cash flow by dividing it by the discount rate.
Step 3: Repeat the same process for the next 5 or 10 years depending on your investment horizon to find the Net Present value of all the Future Cash Flows.
Step 4: Once done with this, add all the present values of cash flows to arrive at present value of all the future cash flows.
Step 5: The fifth step involves calculating Perpetual Present Value of the stock, by dividing 10th year of Free Cash Flow with the difference between discount rate and Perpetuity Growth Rate. This will give you a perpetual present value of the stock.
Step 6: Add the Perpetual Present Value to the Present Value of 10 years of Cash Flows to arrive at the discounted market capitalization
Step 7: Finally, Divide the discounted market capitalization by total number of outstanding shares to arrive at the fair value of the stock.
If the market price of the stock is lower than the fair price of the stock, the stock is considered to be undervalued. On the other hand, if the market price of the stock is higher than the fair value of the stock, the stock is considered to be overvalued.
That is, that is all it takes to value a stock using discounted cash flow analysis.
An Important Note: Don’t Take Your Assumptions Too Seriously
Remember, since fair value of a stock is based on assumptions about the estimated future growth of a business, being prone to error of judgement, your valuation about the stock is as precise as your assumptions about its future.
In other words, there is no such thing as “precise valuation” and no valuation method guarantees that the company will grow at the exact rate you have assumed in your DCF model.
In order to safeguard your investment from any error of judgement, it always better to keep revising your estimates frequently depending on how the company is performing or if there is any change that may impact the financial performance of the company.
Some Pitfalls of Discounted Cash Flow Valuation:
There are always two sides of a coin, and so is the case for Discounted Cash Flow Analysis. Now that you have understood the approach to Discounted Cash Flow Analysis, it is also important to make yourself aware of the pitfalls related to using it.
You Reap What You Sow
DCF is a powerful tool, but it is as good as your own inputs and assumptions. A small change in input can drastically change the outcomes(try to change the perpetual growth rate from 2% to 1%, and you will see how dramatically different the results are.
If the inputs used and estimates made about the future growth are garbage, the valuations arrived will also be inaccurate as well. It is thus important to be very realistic while making assumptions and choosing inputs as they have the potential to make or break the accuracy of your valuation.
You Never Start With a Clean Slate
You need a reason to value a stock, whether you like its business or have just heard about it from your friend, there is always a reason behind why you start valuing a stock.
The reason behind why you pick a stock to analyze itself makes you biased towards or against it.
Almost all your DIscounted Cash Flow Analysis is done to prove or disprove a hypothesis. If you feel that a company will do well, your analysis will reflect it with higher growth estimates. On the other hand if you feel that company may not perform very well, same will be reflected in your estimated growth rates.
Final Words
DCF is the most powerful method of valuing stocks, used all over the world not just by the analysts, but some of the biggest investment bankers. Successful investors like Warren Buffett have always been relying on DCF analysis model for making their investment decision.
The best way to perform a Discounted Cash Flow analysis is to keep it as simple as possible, avoiding too many variable inputs and making too many assumptions.
If you can value a business using 3 variables, don’t use 5, and if you can project the cash flows upto 5 years, there is no point to go upto next 10 years. Simpler the model is, better will be the results.
That’s a wrap on how to value a stock using discounted cash flow analysis. I hope you found this article useful and knowledgeable, if you have any queries, feel free to leave them in comment, I would love to hear from you.