Module 3   Fundamental AnalysisChapter 15

Equity Research (Part 2)

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15.1 – Getting started with the DCF Analysis

We discussed about “The Net Present Value (NPV)” in the previous chapter. NPV plays a very important role in the DCF valuation model. Having understood this concept, we now need to understand a few other topics that are related to DCF valuation model. In fact, we will learn more about these concepts by implementing the DCF model on Amara Raja Batteries Limited (ARBL). With this, we will conclude the 3rd stage of Equity Research i.e ‘The Valuation’.

In the previous chapter in order to evaluate the price of the pizza machine, we looked at the future cash flows from the pizza machine and discounted them back to get the present value. We added all the present value of future cash flows to get the NPV. Towards the end of the previous chapter we also toyed around with the idea –What will happen if the pizza machine is replaced by the company’s stock? Well, in that case we just need an estimate of the future cash flows from the company and we will be in a position to price the company’s stock.

But what cash flow are we talking about? And how do we forecast the future cash flow for a company?

M3-Ch15-title

15.1 – The Free Cash Flow (FCF)

The cash flow that we need to consider for the DCF Analysis is called the “Free Cash flow (FCF)” of the company. The free cash flow is basically the excess operating cash that the company generates after accounting for capital expenditures such as buying land, building and equipment. This is the cash that shareholders enjoy after accounting for the capital expenditures. The mark of a healthy business eventually depends on how much free cash it can generate.

Thus, the free cash is the amount of cash the company is left with after it has paid all its expenses including investments.

When the company has free cash flows, it indicates the company is a healthy company.  Hence investors often look out of such companies whose share prices are undervalued but who have high or rising free cash flow, as they believe over time the disparity will disappear as the share price will soon increase.

Thus the Free cash flow helps us know if the company has generated earnings in a year or not. Hence as an investor to assess the company’s true financial health, look at the free cash flow besides the earnings.

FCF for any company can be calculated easily by looking at the cash flow statement. The formula is –

FCF = Cash from Operating Activities – Capital Expenditures

Let us calculate the FCF for the last 3 financial years for ARBL –

Particular 2011 -12 2012 -13 2013 -14
Cash from Operating Activities (after income tax) Rs.296.28 Crs Rs.335.46 Rs.278.7
Capital Expenditures Rs.86.58 Rs.72.47 Rs.330.3
Free Cash Flow (FCF) Rs.209.7 Rs.262.99 (Rs.51.6)

Here is the snapshot of ARBL’s FY14 annual report from where you can calculate the free cash flow –

M3-ch15-chart1

Please note, the Net cash from operating activities is computed after adjusting for income tax. The net cash from operating activities is highlighted in green, and the capital expenditure is highlighted in red.

You may now have a fair point in your mind  – When the idea is to calculate the future free cash flow, why are we calculating the historical free cash flow? Well, the reason is simple, while working on the DCF model, we need to predict the future free cash flow. The best way to predict the future free cash flow is by estimating the historical average free cash flow and then sequentially growing the free cash flow by a certain rate.. This is a standard practice in the industry.

Now, by how much do we grow the free cash flow is the next big question? Well, the growth rate you would assume should be as conservative as possible. I personally like to estimate the FCF for at least 10 years. I do this by growing the cash flow at a certain rate for the first 5 years, and then I factor in a lower rate for the next five years. If you are getting a little confused here,  I would encourage you to go through the following step by step calculation for a better clarity.

Step 1 – Estimate the average free cash flow

As the first step, I estimate the average cash flow for the last 3 years for ARBL –

= 209.7 + 262.99 + (51.6) / 3

=Rs.140.36  Crs

The reason for taking the average cash flow for the last 3 years is to ensure, we are averaging out extreme cash flows, and also accounting for the cyclical nature of the business. For example in case of ARBL, the latest year cash flow is negative at Rs.51.6 Crs. Clearly this is not a true representation of ARBL’s cash flow, hence for this reason it is always advisable to take the average free cash flow figures.

Step 2 – Identify the growth rate

Select a rate which you think is reasonable. This is the rate at which, the average cash flow will grow going forward.  I usually prefer to grow the FCF in 2 stages. The first stage deals with the first 5 years and the 2nd stage deals with the last 5 years. Specifically with reference to ARBL, I prefer to use 18% for the first 5 years and around 10% for the next five years. If the company under consideration is a mature company, that has grown to a certain size (as in a large cap company), I would prefer to use a growth rate of 15% and 10% respectively. The idea here is to be as conservative as possible.

Step 3 – Estimate the future cash flows

We know the average cash flow for 2013 -14 is Rs.140.26 Crs. At 18% growth, the cash flow for the year 2014 – 2015 is estimated to be –

= 140.36 * (1+18%)

= Rs. 165.62 Crs.

The free cash flow for the year 2015 – 2016 is estimated to be –

165.62 * (1 + 18%)

= Rs. 195.43 Crs.

So on and so forth. Here is a table that gives the detailed calculation…

Estimate of future cash flow –

Sl No Year Growth rate assumed Future Cash flow (INR Crs)
01 2014 – 15 18% 165.62
02 2015 – 16 18% 195.43
03 2016 – 17 18% 230.61
04 2017 – 18 18% 272.12
05 2018 – 19 18% 321.10
06 2019 – 20 10% 353.21
07 2020 – 21 10% 388.53
08 2021 – 22 10% 427.38
09 2022 – 23 10% 470.11
10 2023 – 24 10% 517.12

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 literally 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 18% and 10% growth rate for the future, these are fairly conservative growth rate numbers for a well managed and growing company.

15.2 – The Terminal Value

We have tried to predict the future free cash flow for upto 10 years. But what would happen to the company after the 10th year? Would it cease to exist? Well, it would not. A company is expected to be a ‘going concern’ which continues to exist forever. This also means as long as the company exists, there is some amount of free cash being generated. However as companies mature, the rate at which the free cash is generated starts to diminish.

The rate at which the free cash flow grows beyond 10 years (2024 onwards) is called the “Terminal Growth Rate”. Usually the terminal growth rate is considered to be less than 5%. I personally like to set this rate between 3-4%, and never beyond that.

The “Terminal Value” is the sum of all the future free cash flow, beyond the 10th year, also called the terminal year. To calculate the terminal value we just have to take the cash flow of the 10th year and grow it at the terminal growth rate. However, the formula to do this is different as we are calculating the value literally to infinity.

Terminal Value = FCF * (1 + Terminal Growth Rate) / (Discount Rate – Terminal growth rate)

Do note, the FCF used in the terminal value calculation is that of the 10th year. Let us calculate the terminal value for ARBL considering a discount rate of 9% and terminal growth rate of 3.5% :

= 517.12 *(1+ 3.5%) / (9% – 3.5%)

= Rs.9731.25 Crs

15.3 – The Net Present Value (NPV)

We know the future free cash flow for the next 10 years and we also know the terminal value (which is the future free cash flow of ARBL beyond the 10th year and upto infinity). We now need to find out the value of these cash flows in today’s terms. As you may recall, this is the present value calculation. Once we find out the present value, we will add up these present values to estimate the net present value (NPV) of ARBL.

We will assume the discount rate at 9%.

For example in 2015 – 16 (2 years from now) ARBL is expected to receive Rs.195.29 Crs. At 9% discount rate the present value would be –

= 195.29 / (1+9%)^2

= Rs.164.37 Crs

So here is how the present value of the future cash flows stack up –

Sl No Year Growth rate Future Cash flow (INR Crs) Present Value (INR Crs)
1 2014 – 15 18% 165.62 151.94
2 2015 – 16 18% 195.29 164.37
3 2016 – 17 18% 230.45 177.94
4 2017 – 18 18% 271.93 192.72
5 2018 – 19 18% 320.88 208.63
6 2019 – 20 10% 352.96 210.54
7 2020 – 21 10% 388.26 212.48
8 2021 – 22 10% 427.09 214.43
9 2022 – 23 10% 470.11 216.55
10 2023 – 24 10% 517.12 218.54
Net Present Value (NPV) of future free cash flows Rs.1968.14 Crs

Along with this, we also need to calculate the net present value for the terminal value, to calculate this we simply discount the terminal value by discount rate –

= 9731.25 / (1+9%)^10

= Rs.4110.69 Crs

Therefore, the sum of the present values of the cash flows is = NPV of future free cash flows + PV of terminal value

= 1968.14 + 4110.69

= Rs.6078.83 Crs

This means standing today and looking into the future, I expect ARBL to generate a total free cash flow of Rs.6078.83 Crs all of which would belong to the shareholders of ARBL.

15.4 – The Share Price

We are now at the very last step of the DCF analysis. We will now calculate the share price of ARBL based on the future free cash flow of the firm.

We now know the total free cash flow that ARBL is likely to generate. We also know the number of shares outstanding in the markets. Dividing the total free cash flow by the total number of shares would give us the per share price of ARBL.

However before doing that we need to calculate the value of ‘Net Debt’ from the company’s balance sheet. Net debt is the current year total debt minus current year cash & cash balance.

Net Debt = Current Year Total Debt – Cash & Cash Balance

For ARBL this would be (based on FY14 Balance sheet) –

Net Debt  = 75.94 – 294.5

= (Rs.218.6 Crs)

A negative sign indicates that the company has more cash than debt. This naturally has to be added to the total present value of free cash flows.

= Rs.6078.83 Crs – (Rs. 218.6 Crs)

= Rs.6297.43 Crs

Dividing the above number by the total number of shares should give us the share price of the company also called the intrinsic value of the company.

Share Price = Total Present Value of Free Cash flow / Total Number of shares

We know from ARBL’s annual report the total number of outstanding shares is 17.081 Crs. Hence the intrinsic value or the per share value is –

= Rs.6297.43 Crs / 17.081 Crs

~ Rs.368 per share!

This in fact is the final output of the DCF model.

15.5 – Modeling Error & the intrinsic value band

The DCF model though quite scientific is built on a bunch of assumptions. Making assumptions, especially in finance takes on an art form. You get better at it, as you progress through and gain more experience. Hence for all practical purposes, it is advisable for us to assume (yet another assumptionJ ) that we have made a few errors while making the intrinsic value calculation and hence we should accommodate for modeling errors.

A leeway for the modeling error simply allows us to be a flexible with the calculation of the per share value. I personally prefer to add + 10% as an upper band and – 10% as the lower band for what I perceive as the intrinsic value of the stock.

Applying that on our calculation –

Lower intrinsic value = 368 * (1- 10%) = Rs. 331

Upper intrinsic value = Rs.405

Hence, instead of assuming Rs.368 as the fair value of the stock, I would now assume that the stock is fairly valued between 331 and 405. This would be the intrinsic value band.

Now keeping this value in perspective, we check the market value of the stock. Based on its current market price we conclude the following –

  1. If the stock price is below the lower intrinsic value band, then we consider the stock to be undervalued, hence one should look at buying the stock
  2. If the stock price is within the intrinsic value band, then the stock is considered fairly valued. While no fresh buy is advisable, one can continue to hold on to the stock if not for adding more to the existing positions
  3. If the stock price is above the higher intrinsic value band, the stock is considered overvalued. The investor can either book profits at these levels or continue to stay put. But should certainly not buy at these levels.

Keeping these guidelines, we could check for the stock price of Amara Raja Batteries Limited as of today (2nd Dec 2014). Here is a snapshot from the NSE’s website –

M3-ch15-chart2

The stock is trading at Rs.726.70 per share! Way higher than the upper limit of the intrinsic value band. Clearly buying the stock at these levels implies one is buying at extremely high valuations.

15.6 –Spotting buying opportunities

Long term investment and activities surrounding long term investing is like a slow moving locomotive train. Active trading on the other hand is like the fast bullet train.  When long term value opportunity is created, the opportunity lingers in the market for a while. It does not really disappear in a hurry. For instance, we now know that Amara Raja Batteries Limited is overvalued at current market price as it is trading way higher than the upper limit of the intrinsic value band. But the scene was totally different a year ago. Recall based on FY 2013- 2014, ARBL’s intrinsic value band is between Rs. 331 and Rs.405.

Here is the chart of ARBL –

M3-ch15-chart3

The blue highlight clearly shows that, the stock was comfortable trading within the band for almost 5 months! You could have bought the stock anytime during the year. After buying, all you had to do was stay put for the returns to roll!

In fact this is the reason why they say – Bear markets create value. The whole of last year (2013) the markets were bearish, creating valuable buying opportunities in quality stocks.

15.7 – Conclusion

Over the last 3 chapters, we have looked at different aspects of equity research. As you may have realized, equity research is simply the process of inspecting the company from three different perspectives (stages).

In stage 1, we looked at the qualitative aspects of the company. At this stage, we figured out who, what, when, how, and why of the company. I consider this as an extremely crucial stage of equity research. If something is not really convincing here, I do not proceed further. Remember markets are an ocean of opportunities, so do not force yourself to commit on to an opportunity that does not give you the right vibe.

I proceed to stage 2 only after I am 100% convinced with my findings in stage 1. Stage 2 is basically the application of the standard checklist, where we evaluate the performance of the company. The checklist that we have discussed is just my version, of what I think is a fairly good checklist. I would encourage you to build your own checklist, but make sure you have a reasonable logic while including each checklist item.

Assuming the company clears both stage 1 and 2 of equity research, I proceed to equity research stage 3. In stage 3, we evaluate the intrinsic value of the stock and compare it with the market value. If the stock is trading cheaper than the intrinsic value, then the stock is considered a good buy. Else it is not.

When all the 3 stages align to your satisfaction, then you certainly would have the conviction to own the stock. Once you buy, stay put, ignore the daily volatility (that is in fact the virtue of capital markets) and let the markets take its own course.

Please note, I have included a DCF Model on ARBL, which I have built on excel. You could download this and use it as a calculator for other companies as well.


Key takeaways from this chapter

  1. The free cash flow (FCF) for the company is calculated by deducting the capital expenditures from the net cash from operating activates
  2. The free cash flow tracks the money left over for the investors
  3. The latest year FCF is used to forecast the future year’s cash flow
  4. The growth rate at which the FCF is grown has to be conservative
  5. Terminal growth rate is the rate at which the company’s cash flow is supposed to grow beyond the terminal year
  6. The terminal value is the value of the cash flow the company generates from the terminal year upto infinity
  7. The future cash flow including the terminal value has to be discounted back to today’s value
  8. The sum of all the discounted cash flows (including the terminal value) is the total net present value of cash flows
  9. From the total net present value of cash flows, the net debt has to be adjusted. Dividing this by the total number of shares gives us the per share value of the company
  10. One needs to accommodate for modeling errors by including a 10% band around the share price
  11. By including a 10% leeway we create a intrinsic value band
  12. Stock trading below the range is considered a good buy, while the stock price above the intrinsic value band is considered expensive
  13. Wealth is created by long term ownership of undervalued stocks
  14. Thus, the DCF analysis helps the investors to identify whether the current share price of the company is justified or not.

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  1. Harshad Salvi says:

    Hi, Few Questions…
    1. On what basis should one select the future growth rate of FCF? Has it got to do anything with Profit growth rate(NP or GP)? if not, then
    how should we determine the growth rate?
    2. Why did you select the discount rate of 9%? Is it related to Cost of Capital (or WACC) of the Co.?
    3. The above exercise is based upon FY14 results summary. The results must have been out somewhere in the month of April or so. Then,
    how could one have purchased the stock in FY13-14 only without knowing what the results are going to be? And also, the stock was seen
    trading closer to the upper band of the intrinsic value (in the month of February-March), which doesn’t warrant adding stock to one’s
    kitty. In other words, it appears to have traded at around fair value. Then why would one invest in the said stock once results were out.

    • Karthik Rangappa says:

      My answers in line –

      1) This is the hard part, there is no clear basis that is prescribed. I personally prefer to be as conservative as possible when it comes to setting the FCF rate. I never exceed 20%. Besides, I prefer the 2 stage DCF process where I have two different FCF rate.

      2) Yes, the discount rate is nothing but the weighted average cost of capital (WACC). 9% is probably a bit low, I should kept it at probably 10 -11%. In fact this is the reason why I have given the excel link, people can feed in their desired rate and play around.

      3) You maybe right on the 3rd point, not sure how I erred here. Let me re-look and if required rewrite.

  2. Harshad Salvi says:

    Would you pls explain what constitutes Large Cap, Mid cap & small cap cos?

    • Karthik Rangappa says:

      I personally use this classification –

      1) Between 50 – 500 Crs of MC – Ultra Micro Cap
      2) Between 500 – 2000 Crs of MC – Micro Cap
      3) Between 2000 – 10K Crs MC – Small Cap
      4) 10K to 25K MC – Mid Cap
      5) Above 25K MC – Large Cap

      Note MC = Market Capitalization.

  3. Keerthan says:

    Karthik, from FCF that is Cash from OA-Capex you have arrived at Cash from Op Activity-Capex-Net Debt that is FCFE right? Why is Interest*(1-t) missing in the equation?(FCFF). Could you explain these concepts? FCF,FCFF and FCFE?

    • Karthik Rangappa says:

      FCF/FCFF = Free cash flow to the Firm. A firm includes both deb holders and equity holders. FCF conveys to us how much cash the company is generating for both these types of holders. However if we have to find out the cash component specifically for equity holders then we got to look at ‘Free Cash flow to Equity’ or FCFE. FCFE gives us the cash component applicable to the equity holders of the firm. Yes, taking interest*(1-tax rate) makes sense but I guess since the interest component was very low, I must have skipped it. By taking interest*(1-tax rate) we are actually accounting for the tax shield the company enjoys by paying an interest to debt holders.

      • Keerthan says:

        OK. I just came across Zerodha Varsity last weekend and I must say I am very impressed with the material. It is very simple, lucid and clear. I have some suggestions for you. Both TA and FA modules are very good.
        1) In TA you could also look at adding a chapter on Elliot Waves. It is an extremely helpful tool.
        2) In FA you could also add a module on relative valuation methods, (P/E, EV/EBITDA, Market capitalisation/Free cashflow yield, Enterprise value/Free cash flow yield etc). These valuation methods are equally good especially the one’s involving cashflow yields.
        3) You could also be a module on valuation metrics in different sectors for general understanding (Cement, IT, FMCG, Realty etc).
        4) There could be a brief write up on taxation as well( LTCG,STCG etc)
        Even if you so not add any of these, It is still an excellent job so far.

        • Keerthan says:

          Correction-
          3) There could be a module/ write up on valuation metrics in different sectors for general understanding (Cement, IT, FMCG, Realty etc).

        • Karthik Rangappa says:

          Thanks for you kind words. Zerodha has taken a lot of efforts to build Varsity…it is still in a early stage, it will have a lot more content as we go forward. Will try and include all the topics you have suggested, please stay tuned. Right now the focus is on Futures and Options as there are many request coming in for these modules.

  4. Keerthan says:

    Hi Karthik, I was looking at the attached cash flow statement, Could you tell me whether Purchase of Fixed Assets Including Capital work in progress and Capital advances can be considered as CAPEX for finding out the FCF or should we take out CWIP and Capital advances from the given value?

    • Keerthan says:

      Hi Karthik, another question related to the above image.
      In the attached image above, as you can see there is a significant Finance cost involved. So I take it that we add (1-tax)*Interest to FCF to calculate FCFE. That is FCFE=CFOA-Capex+(1-tax)*Interest+NetDebt.
      I have the following questions – 1) For Interest*(1-tax), I consider only Interest costs out of total finance costs right? The other cost in the total Finance cost here is Foreign exchange loss.
      2) (1-tax), here is the tax rate; Current tax/EBT? or Total tax(Current +Deferred+Taxes of earlier year)/EBT?

      • Karthik Rangappa says:

        Yes, you will have to account for the benefit of tax shield that the company enjoys by virtue of paying interest. The formula what you have stated is correct. Forex loss should not be included in this calculation. (1-tax), here the tax referred to is not the tax amount, it refers to the corporate tax rate, which is a % figure. Usually about 34%.

    • Karthik Rangappa says:

      Keerthan – You can include this in FCF calculation.

  5. Keerthan says:

    Hi Karthik, Instead of taking the projected values of FCFF , finding the NPV and then subtracting Net Debt to find FCFE, can’t we calculate FCFE for say 5 years, find the average and then project the future values on this average growth value?

    • Karthik Rangappa says:

      You can, if fact that is what you do when you build a financial model. I dint discuss that as I thought it could be a bit heavy. Maybe I’ll introduce a module on Financial Modelling at some point in the future 🙂

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