Discounted Cash Flow

How to calculate Value of Business by discounted cash flow analysis
Let the financial experts talk and speak whatever financial jargon’s they like but ultimately all stock market investment decisions bottoms down to the following two basic questions:

1) What is the value of business / company in consideration?
2) Is the right time to buy its stocks (whether current price is too high or OK for buying)?

Let me tell you, if an investor can answer the above two questions his majority job is done. After doing this analysis an investors will know which company is value for money and whether it is a right time to buy this stock.

Let’s see how this can be done by people like you and me who are not financial experts but like to invest in stocks like The Mr. Warren Buffett. Just keep in mind one small concept, in terms of stock purchase “Price is what one pays to buy a stock and value if what you get out of this stock in long term perspective”.

Remember this analysis in not for stock traders who likes to buy stocks today and sell it tomorrow for petty profits. This content is addressed to everybody who is interested for long term investment and would like to benefit and grow with the company (the stocks that one owns).

Another important thing that I would like my readers to note that due to speculative nature of stock prices, the price of stocks keep on fluctuating above and below is actual value (worth). An investor must buy stocks when the price of stock goes below it value. Generally we buy stocks without knowing its value (worth). We compare the day to day prices of stocks and make decisions to buy or sell. This is ok if the prices falls by a huge margin (like during recent financial crisis), but how to take decisions when prices are falling only like 50-60 odd basis points? This is where the business value theory will come helpful for investors.

The process of calculating the value of business is called “intrinsic value” calculation for a business. In addition to the process that we are going to discuss in detail, other very useful thumb rules for determining intrinsic value of company is as listed below:

1) Low Price to Earning (P/E) Ratio
2) Low Price to Book Value Ratio
3) High Dividend Yield.

But the process of intrinsic value calculation that is used by Mr. Buffett is called the “Discounted cash flow model”. Discounted cash flow model concept asks an investor to the following:

1) Calculate the expected earning (owners earning) over a period of time.
2) The calculated earning should be discounted by an acceptable interest rate. In other words it called calculating the Present Value (PV) of future cash flow.

Stock Price and Value of Business
In order to know that whether a business has more value than its market price we shall calculate the value of business (it is expected to achieve over a course of time) and divide it by number of outstanding shares in the market. If value/share is more than the current market price/share then it means share can be purchased.
Market price /share < Value of business /share

Value of Business
In order to calculate the value of business (it is expected to achieve over a course of time), it is important to know owners income for that year. The owners income for that year should be translated into present value (because a dollar in hand today is more strong that a dollar in hand in the future). The present value of future owner’s income when divided with the capitalization rate gives the value of business.

Value Business /share = (Owners income for that year / capitalization rate) + (present value of all future cash flows say for next 5 year)

Owners Income
It is important to note the difference between Owners Earnings and PAT
Owners income = Profit after tax (PAT) + Depreciation – Capital Expenditure

Warren Buffet believes that all businesses require capital expenditures that are roughly equal to their depreciation rates. It is possible to defer a capital expenditure expenditures for a year or so, but if not done for a long period of time the performance of business will surely decline. According to Warren Buffett these capital expenditures are as important for running a business as it is to pay for the labor salary and for the utilities and raw materials.

I know the above calculation will break the hearts for majority of my readers. But I will give a ready to use guide for calculating the owner’s earnings without doing must of those complicated studies on your own. These days company’s financial reports are easily available online. Access one of those reports for any company and see the cash flow statement declared by the company. Generally a cash flow statement of a company tells us three things:

1. How much cash the business generates (or eats) From Operations,
2. How much it generates (or eats) from Investing Activities, and
3. How much it generates (or eats) from (external) Financing.

But according to Warren Buffett, the above three figures in isolation speaks nothing. To know the owners earnings subtract (2) form (1).

Capitalization Rate
The capitalization rate is composed of two parameters:
(1) Risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as fixed deposit (say 7.25% per annum); minus
(2) Risk premium that an investor must gets as a compensation for the level of risk they have taken by investing in a fixed deposit like investment. (say 5% for any well managed company),

Note: in order to claim/expect for that risk premium all investor must invest for long term.
Capitalization rate = Risk free rate (7.25%) – Risk premium (5%) = 12.25%
Lets take an example of a company “X” and compare its market price/ share with its expected value (in next 10 year) /share and see it this stock is worth investing in.
Step-1
Find the Owners income for last 5 years
In Rs. Crore
Company “X” 2005 2006 2007 2008 2009
Cash generated from Operations, 1,851 1,930 2,141 2,723 3,279
Cash generated from Investing Activities, -1,438 -175 -1,083 -1,737 -1,261
Owners income 413 1,754 1,058 986 2,018
CAGR 49% 413 614 913 1,358 2,018
Step-2
Estimate Owners income for next 5 years.
Consider owners income to grow at a constant growth rate of at least at one-half of the speed of calculated CAGR (49%) for the past 5 years.
In Rs. Crore
Company “X” 2009 2010 2011 2012 2013 2014
Owners Income 2,018 2,533 2,946 3,359 3,772 4,185
CAGR @ 24.5% 515 413 413 413 413 413
Appreciated Income 2,533 2,946 3,359 3,772 4,185 4,598
Step-3
Estimate Capitalization rate
Capitalization rate = risk free rate (7.25%) – risk premium (5% say) = 2.25%
Step-4
Calculate Present value of cash flows for five year (2010 to 2014)
In Rs. Crore
Company “X” 2009 2010 2011 2012 2013 2014
Owners Income 2,018 2,533 2,946 3,359 3,772 4,185
CAGR @ 24.5% 515 413 413 413 413 413
Appreciated Income 2,533 2,946 3,359 3,772 4,185 4,598
Discounted rate @ 9% 0.9100 0.8281 0.7535 0.6856 0.6238
Present Value of owners income 2680 2781 2842 2869 2868
Sum of all PV’s 14040
Step-5
Calculate Market Value of business in term of future cash flows
= (Owners Income for 2014 / Capitalization rate) + (Sum of all PV’s of future cash flows till 2014)
= (4598 / 2.25%) + (14040)
= 204355 + 14040 = Rs 2,18,395 (Crore)
Step-6
Calculate Market Value of business in term of future cash flows / share
Assuming number of outstanding shares as on 2009 is = 377,44,00,000 Nos = 377.44 Cr.
Market value/share = Rs 2,18,395 Cr. / 377 Cr. = Rs 578.6
Step-7
Compare current market price/share with market value/share
Current Market Price = Rs 266.85
Current market value calculated in terms of future cash flows = Rs 578.6
It means there is phenomenal growth prospect (CAGR 21%) of this stock in next five years.