## 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 3^{rd} 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?

## 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 –

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 2^{nd} 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 10^{th} 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 10^{th} year, also called the terminal year. To calculate the terminal value we just have to take the cash flow of the 10^{th} 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 10^{th} 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 10^{th} 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 –

- 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
- 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
- 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 (2^{nd} Dec 2014). Here is a snapshot from the NSE’s website –

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 –

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

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

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.

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.

Hi Karthik,

Do you still vouch for above example’s validity in the context of the fundamental concepts taught by you…

Sorry, dint get that…are you talking about ARBL?

Yeah, Very much. The point no.3 in our discussion

Harshad – I have made the necessary correction in the chapter.

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

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.

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?

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.

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.

Correction-

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

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.

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?

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?

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%.

Keerthan – You can include this in FCF calculation.

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?

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 🙂

In “= 9724.89 / (1+9%)^10” what mean of symbol of “^”. pls explain because I no read it in normal maths.

The symbol ‘^’ means – raised to the power of. So in the mathematical expression – “9724.89 / (1+9%)^10”, it means the number 9724.89 is divided by (1+9%) which is (1.09) raise to the power of 10.

Hi Karhtik,

I have a query on DCF calculation. Here goes the question

1) When a company like for example KNR constructions has subsidiaries and hence consolidated financial statements, then do I use the values from consolidated balance sheets for DCF calculations?

2) In case of KNR, if I use the consolidated statements I get a negative value for average free cash flow (I took 3 years, then 2 more years making it 5 year average) and hence negative PV’s. However If I take the standalone values which are much better I get a positive value and considering the results of the 2 quarters of FY2015 which have already passed and estimated 3QFY15 values, the stock price comes very near to what it is presently trading at in the spot markets. I would like to have your view on this.

It is always a good practice to look into the consolidated numbers. Imagine this – a person could be earning a great salary on a month on month basis, but if he lives in a joint family with 10 dependents on him, draining away all the money he earns, then obviously his salary pales in comparison to his monthly liabilities. The family is his, and one cannot really separate it from him. Like wise with standalone and consolidate numbers. In fact there are companies which on a standalone basis has horrible numbers but on a consolidated basis the whole scene changes.

In case of banks and Financial Institutions, mostly CashFlow is negative and excel sheet shows wrong Valuation data.

Any idea how can we do valuations in case of negative net cash flow ??

Valuation of banks is a little tricky. Will try and upload a chapter on this soon.

How does greece crisis affect the indian share market?

Experts suggest that Greece is not a major trading partner with India…so it should not really affect us much.

Bro for DCF analysis which report is more suitable?

Standalone or consolidated??

Consolidated statements for everything!

Bro when you was explaning DCF analysis taking example of ARBL

you calculated Net Debt=Total Debt-Cash and cash Balances

Here you took total debt= Long term Borrowings

But it should be Long term Borrowings+Short term Debt

Explain?

Yeah, I guess I omitted Short term debt because it does not exist for ARBL. Also the ‘short term borrowings’ present in BS is ‘Current’, which is not really considered in DCF.

Bro in all bs, short term debts are taken in current liabilities??

Why you have not taken in dcf analysis

Whether to take it or not

Explain

Nikhil – Yes, please do include it.

Hi Kartik,

Can you please explain, how to calculated Current Year Total Debt & Cash & Cash Balance.

Is Current Year Total debt = Current Liability + Non Current Liabilities ?

and Cash & Cash Balance = Reserves and Surplus ?

Regards

Total Debt = Long term debt + short term debt

Cash & Cash balance = As stated in the Balance sheet, no need to calculate. However you can consider adding ‘Investments’ to Cash & Cash balance provide the investments are all liquid in nature (such as liquid funds, short term debt products etc).

I think the figures of future cash flow are wrong, there may be calculation mistakes. Please check as I am getting these, please see the attached file

517.12* (4.5)/(9-3.5). Is not equal to 9000 crores, please rectify the figures, m getting doubt over my calculations

Oh sorry, my bad, rates not divided by 100.

Thanks, you got me worrying for a minute 🙂

respected sir, you have derive FCF = Cash from Operating Activites – Capital Expenditures, for the year 2013-14 i.e. Cash from Operating activities (after income tax) Rs.278.70 and Capital Expenditures Rs. 330.30 in P&L statement for the year 2013-14 i could not understand. please calculate Rs. 278.70 and 330.30 how it comes? Thanks a lot.

Sure, will check again and get back as soon as I can. Thanks.

Hi Nishu,

The Free cash flow (FCF) represents the total value of the business. It is calculated as follows :

FCF = Net cash from operating activities – Amount paid to purchase tangible fixed assets

FCF (2013) = 335.46 – 72.47 = 262.99

FCF (2014) = 278.75 – 330.36 = (51.66)

Please click on this link from the ARBL Cash flow statement to understand the computation.

Kindly provide the link.i am also confused.

Plz help.thnx

Which link, Samir? All the links are available in the chapter.

respected sir,………… if possible please give my answer as early as you can………..please…….thanks

Hi Karthik,

I am doing DCF analysis for L&T with the excel sheet provided above and Free Cash Flow average is Negative value for L&T. So the approx. share price is showing wrong values.

1) Can you explain how to do DCF analysis for companies with Negative Cash flows ?

2) If DCF analysis can’t be applied for Negative Cash flow means, is there any other method to determine approx. values ? Any specific method names ?

Billa -its hard to model companies with -ve cash flow since most of the input variables are ‘rough estimate’. Also the reliability is mainly on the terminal value in case of -ve cashflows…also do remember terminal value is sensitive to discount rate.

In such situations I usually go by other valuation techniques – P/E, comparables, P/BV etc.

as said by you sir

FCF is the base for dcf, but why do I have to forecast my future FCF on an average historical FCF

Without forecasting how else would you gain visibility on the future cash flow? The idea is to keep it ultra conservative and realistic.

Sir how accurate are the intrinsic values that are provided by screener.in ?

Not sure Akshay.

Hi,

While calculating Net debt should we deduct Cash and cash balance from long term borrowing?

why we will not consider short term borrowing?

Because, short term debt is a current item, however Net Debt represents a longer term picture.

Hi,

How do we get information about company’s auditors,bankers whether they good or not?

You will get to know the names in the Annual Report. How good or bad they are is something you will have to figure out by means of research 🙂

If I would have calculated future value and PV for infosys 15 yrs back and eicher motor 6 yrs back. chances were that it intrinsic value of stock may have come in overvalued range after 1-2 yrs of calculation.

So I would have exited, but How to know that its not overvalued and still potential growth is left in stock/company?

Such investment decisions go beyond number crunching abilities. You should be able to assess companies management, business model, scale etc. This is where qualitative research comes into play.

Sir…What is the ”Diluted” number of share ?

Is that this kind of share count when finding intrinsic value per Share?(in case of infosis)

Diluted generally includes the total shareholding plus the authorized shares for issuance.

That mean they do not counting for calculation of intrinsic value per share?

Ex….Number of share used in computing earnings per share (Infosis)

Basic 1148472332 (only this are count)

Diluted 1148487674

If you want to be highly conservative then you can the diluted numbers.

what are the major global events and regulatory statements impact on Indain stock market? how can get this information on website?

As far as Global events are concerned, the main one if the FED monetary policy. For Indian events, check this – http://zerodha.com/varsity/chapter/key-events-and-their-impact-on-markets/

Hi,

How to see Indian economic and global events ? any web link?

This is a useful site – http://mospi.nic.in/Mospi_New/site/home.aspx

Please elaborate the term WACC. How to calculate it ? or find it for Terminal Growth Value ?

Can we infer that the more the difference in CMP to Intrinsic Value, the better stock to BUY, than vice-versa?

eg.

Scrip-A. CMP 100, IV 1000

Scrip-B. CMP 900, IV 1000

Can we infer that buying Scrip-A would be a better choice?

If the difference (scrip A) is so much, then you need to dig deeper and figure out why the difference is so much. But generally yes, higher the difference better it is !

Hi,

Can you elaborate on WACC or discount rate that is used in Terminal value calculation. Can we always keep it 9% to 10% or will it vary from company to company?

Weight average cost of capital (WACC) gives us an idea of the rate at which the company is borrowing funds. To put it in a simple way – if you avail a personal loan form the bank at 12%, then WACC in your case is 12%.

Terminal Value – a company is expected to exist to perpetuity. So if it continues to exist forever, then it is supposed to grow at a certain rate. The average rate at which it will continue to grow is called ‘Terminal Value’.

Thanks Karthik. This is an excellent things you guys have done. Really appreciate Zerodha’s effort to put this together.

Thank you 🙂

Hello Karthik,

What are your criteria for selecting growth rate for first 5 years??Is it vary from company to company??Same question for Discount rate??

Yes, it would vary company to company, sector to sector. This would largely depend on your understanding of the business and the sector. There are no set rules here. However, keeping the numbers conservative is the key.

What is Discount Rate?

Rate at which you discount the future cash flow. Discount here has a literal meaning.

What does the lower price band and upper price band on NSE site indicate ?

Stock price movement on a daily basis can be controlled by exchanges to curb excess volatility. If a stock has a 5% upper and lower price band, then it means it can move up by a maximum of 5% and down by 5% for the given day.

can we take 5 years average free cash flow in place of 3 years ?

Yes, you could.

should we use tangible fixed assets only or Purchase of fixed assets, including capital

work–in–progress and capital advance ? If so , how do we find only the Tangible fixed assets ?

Thank You .

The schedule associated to Fixed assets usually gives this information along with the accumulated depreciation as well. Suggest you look into it. Thanks.

First of all Karthik, I would like to thank you very sincerely and literally from the bottom of my heart for putting the entire module of fundamental analysis together. I have minutely followed till financial ratios (chapter 10) and have skimmed through the rest of the chapters due to prior familiarity with DCF and CAPM. And I can tell how much effort you must have put in to compile all this write-up.

I also started as an enthusiast, did a finance basics course, learnt a theory about present values, asset pricing and CAPM but still in practice, somehow I used to get stuck till Anual Report analysis (I have not yet done corporate finance course.) Somehow, I was not getting the link of connecting the real financial statements of a company to theoritical financial models.

I feel this is yet another reason to respect your effort as you have seamlessly tied all the three important aspects of fundamental analysis together.

1. Reading anual reports and financial statements

2. Using and moreover deriving financial ratios and taking out meaning of it, and

3. Fair value calculation.

Hats off!

If you wouldn’t mind I have few tweaking suggestions and requests for individual topics in the chapters. I will put individual comments wherever applicable (and as I read again :D). I genuinely feel that will make this material even more well rounded.

Thanks and Regards,

Chad

Many thanks for the very kind words and the encouragement Chad.

I know the efforts are worth it when people take time to read this…and more importantly benefit from it. Please do share your feedback and I’ll be happy to work around it.

Dear Karthik

The % no. like you took 18%, 9%, 8.5% those things are you took by yourself or by any rules & regulations?

Thanks a lot

No rules as such, you put these numbers based on experience.

One another question my is that, I’m going to read FA of a company So first I conclude the intrinsic value or read whole financial statemynts and ratios like first you described all statements and ratios of Amara Raja and in the end of time the intrinsic value is showing not capable to buy the shares right now. Please suggest me I’m beginner. Sorry for my bad English as I already asked you about Hindi modules

Thanks a lot dear

Its exactly the same Sammandar. You have to start with the basic financial statements and progress towards identifying the intrinsic value.

Thanks a lot dear first and I still have some doubts before going further as you described about the Amara Raja in your modules. According to my understanding all stuffs were well & good at this point and in the end after evaluating intrinsic value we are not able to invest right now because of overvalued then in this case, Will we wait till undervalued if will wait then how much time because the difference is too much between current stock price(around 700 & intrinsic value (around 350), . Please tell me what is the right decision in this situation.

Thanks

Yes, usually its a good idea to wait till you get the right opportunity. However, this valuation model is old now, we have lot more data points (in terms of financial data). We need to use this information to check the latest intrinsic value.

Good, Thanks for kind advise

By the way how much time will you take for Hindi modules?

Not sure 🙂

Is there anyway to find the intrinsic value of bank stock. From my view, DCF valuation doesn’t work for banking sector.So pls provide me any source or idea to find the intrinsic value of the bank stocks or any other valuation methodology. Thanks in advance.

Banks are not really my strength Vimal, afraid I wont be able to help much here.

current year total debt = 75.94 which is also the long term borrowings

but long term term in non current debt. and current year debt is always short term borrowings.

can you please explain this.

thanks in advance

Ah, current year refers to the current financial year.

How to take the intrinsic value when the free cash flow is negative because intrinsic value is also negative or there is another method to calculate the intrinsic value when FCF is negative

There is no IV if the CF is -ve.

Thanks a lot for your response all the time.My question is while calculating the intrinsic value we take growth rate for 5 or 10 years.So the value we got is that the growing rate of the company we take and its value is after 5 or 10 years i.e. is we are calculating the present value for fcf of after 5 years.So how we conclude the present worth of the company in today’s term in current financial position.Please correct me if I am wrong.

You add up all the PV of FCF along with cash in bank. Divide this over the existing number of shares and you get an idea of its intrinsic value (based on expected cashflow).

Hi Karthik,

For me it is getting difficult to calculate Infosys intrinsic value. To calculate Net debt when i check total debt , I did not find any debt as such hence I took value as 0. and then cash & cash balance as 32697 hence net debt comes (32697) Please can you check and confirm. This is from annual report 2016

Net debt is Debt – Cash, since Infy does not have any debt, there is no point calculating this at all.

In FCF , only Purchase of tangible fixed assets is considered as capital expenditure. Why are the rest of the expenditures not included ( Purchase of intangible fixed assets,Increase in capital work-in-progress ) ?

What we are essentially looking for is the cash flow generated from operations, essentially current items. Things like fixed asset belongs to non current items.

How do you calculate the discount rate ?

You have to make in intelligent guess. Alternatively, you can take in WACC (weighted average cost of capital) to estimate this. My advise would be to take a number that makes sense and then build a data table which would reflect the changes in the discount rate versus the share price.

How do we calculate the working capital change or we simply take the working capital change in cash flow statements. Please provide me the formula for net working capital where I had lot of confusions here. Thanks in advance.

Working Capital change captures the effect of cash on the cash position.

Anything that tends to increase the cash flow needs to be added and items which tends to decrease the cash position needs to be deducted. I guess the same has been explained earlier in this chapter.

Karthik, I am not quite clear on the denominator part of the terminal value formula. I understand that the numerator part is the FCF till infinity.(Discount Rate – Terminal growth rate) – What does this logically mean? Also, If the interest rate reduces, DCF suggests to pay more price for the same stock. Correct? Thank you! P.s: I am soon going to open an account with Zrodha. Thanks for all your help 🙂

Sure Dhinakaran, Zerodha will be happy to have you as a client! We look forward to your account 🙂

The formula is mathematically deduced from a longer expression (to begin with). I suppose to understand the logic, you will have to understand this derivation. Unfortunately, I don’t have an online link, else I’d have pointed you to the same.

Hi Kartik,

What if Cash Flow is negative number, as in for example of REC.

Well, in that case its hard to estimate a fair value using the DCF approach.

I would really appreciate, if you can guide on how to discover intrinsic value of such companies.

Also, i think similar would be the case for financing companies.

I should have mentioned this earlier –

1) If the CF is -ve for 1 or 2 years but +ve for rest, then it is not a problem. DCF is applicable, just follow the regular steps involved

2) If its -ve all through, I’d suggest you look at relative valuations

Hi Karthik,

WACC , from where we would get for a particular company.

Regards,

MSP

You need to calculate this. It is the weighted average of cost of debt and equity. Usually it is around 10-12% for any company.

In topic 15.4, net debt = current year total debt – cash & cash balance. If it’s in brackets, it’s a negative value, right?……. If the net debt which is -218.6crs, is added to the total present value of free cash flow, it must be 6078.83 – 218.6 = 5860.23crs.

But you have added it giving a value of 6297.43crs……. Can you please explain the calculation, karthik?👨😁

Net debt = Total debt minus cash and cash equivalent

In case of ARBL,

Net Debt = 75.94 – 294.5

= Minus Rs.218.6 Crs

Therefore,

6078.83 minus of minus 218.6

= 6297.43crs 🙂

Hi there,

I have estimated the average cash flow of the company , but as per analyzing the growth rate of the 2 Phases {Phase 1 – Explosive growth , Phase 2 – Moderate Growth } , you in the above example we have used a rigid % figures for the 2 Phases ., now i just want to ask or suggest would it be better if we used the industry standards., as in we just get the average historic growth average (of FCF ) of all the peers .? or maybe any other way you can discuss .? And please submit your response as whether my suggest idea is doable ./feasible and how your suggested idea of using a rigid % growth figures for the 2 phases is more superior/inferior to the idea .?

Looking forward for a satisfying idea !

Please Also suggest a way out when the company i am assessing has a negative average cash flow ( step 1 )

Simple, just avoid it 🙂

Many good opportunities out there.

Of course, you can. Remember, valuation is also an art form! The agenda behind rigid numbers is to keep it conservative.

Dear karthik,

Good job. Easy understanding. I am new to FA.

How one can identify, the transaction of capital expenditures?. I see in annual report, in various titles.

Pl. explain.

regards,

B.Sankar

Thanks Sankar.

Usually, an associated note will give you the details. Capex, for instance will be mentioned in the Gross block section, which is on the asset side of the balance sheet.

Dear Karthik,

I feel there is an error in table (15.3 – The Net Present Value (NPV)) growth rate you have mentioned 18% and subsequent 10% but entire calculation is done on the base of 9% to get the “Present value”.

I request you kindly recheck this…. Tanveer.

Tanveer, 9% is the discount rate, which helps us bring back the future cash flow to present rate. The 18% and 10% used earlier is the growth rate of the the future cashflow.

Hi Karthik,

Total Debt every where you are taking Long Term+Short term, however, at DCF calculation you are taking only long term debt, why so?

Regards,

MSP

For most of the ratios calculation we take total debt, however for DFC we can consider just the long term debt, especially if the short term debt is negligible.

Sir,

Is this the only method to find the intrinsic value? If any other methods are there, then please share link sir.

thank u.

You can do a relative valuation as well…this does not give a you an intrinsic value, but gives you a sense of the current valuation – http://www.investopedia.com/terms/r/relative-valuation-model.asp

Respected Sir,

Thanks a lot for such valuable info & all modules.

I programmed two DCF calculators in excel that helped me & I hope will be useful to others as well. I would like to share it on this platform.

Here are links –

1) 2 Stage DCF Value Calculator (Portable, simple with only takes 3 years data inputs) – bit.ly / 2muDWyv

2) 2 Stage DCF Value Calculator with Margin of Safety (extended for multiple years data inputs) – bit.ly / 2muLuBi

(input cells are highlighted grey color, rest is calculated automatically)

Once again thanks to Zerodha team for great efforts !!!

Regards

James

Thanks for sharing this, James! I’m sure this will help many.

Great Job , karthik Sir . I am really inspired by your write ups .

Sir , i understood the things in complete except the arriving at the FCF.

You said that Free cash flow = Cash flow from Operating activities + CAPEX.

But you added only increase in the tangible fixed assets with CF from operating activities for ARBL’s FY14.

Why dint you add Purchase of Intangible assets or for that matter the purchase of Capital work in progress ??

Are they not a capital expenditure?

Yes, we only take the differential of cash. And CAPEX includes long term expenditures. WC is a short term in nature.

Sorry that would be FCF = Operating activities CF – CAPEX

then why the other two are not subtracted.

SIR ..Not able to understand discount rate for dcf method ….is discount rate equal to risk free interest rate…??

No, it’s not the same as risk free rate. Discount rate is the rate at which you will discount the future cash flow. It can be considered as the opportunity cost.

Hi Sir,

Was performing FA for IOC, i am getting a total present value 908023 and total number of shares is 243 (both values in crores).

The intrinsic value is 3741.34 with upper limit 4115.47 & 3367.20, however the share price is hovering around 406 (when am writing this).

i can see that the intrinsic value has its decimal place shifted to right by 1 position when comparing with actual share price.

Are these decimal point shifts expected in DCF or Should I consider these stocks to be massively undervalued or is it that my calculations has gone wrong somewhere (has double checked, everything looks fine :))

Also, i am seeing 2 types of EPS values (basic & diluted) in the annual reports of many companies, which one should be considered for EPS Growth calculation?

Thanks,

Nirmal

I’d suggest you take the diluted EPS.

I’m guessing you would made an inadvertent error while converting lakhs in crores or some division somewhere….leading to the decimal shift.

Sir, if we calculate the valuation of Sintex industries by the same valuation model, it comes out to be a negative value owing to high value of debt and small operating cash flow. Could you please explain in detail.

I guess the issue would be in their cash flow from operations. If a company is generating -ve cash flow, then estimating their fair value will be a tricky affair.

how to arrive at the fair value of stock in such cases

DCF will help you arrive at a fair value.

Sir,

what’s the difference between growth rate and dimnishing rate?

How to assume the dimnishing rate?

Growth rate is the rate at which any variable growing – could be EPS, Margins etc. Not sure about diminishing rate.

Sir,

How we will know the discount rate through which we have to calculate present value?

You can do this via WACC basis. But I’ve not discussed this. You can assume a 10-12% rate for most of the stocks.

In today’s high speed technology big players or institutions will get intrinsic value (as per model) through alerts and algorithms which may create arbitrage opportunity between IV and CMP and they will be the first to fill that gap and take profit, do retail investors have an edge after doing all the hard work (fundamentally) in today’s trading environment?

Of course, FA is anything but an HFT environment. When a stock is trading at sub IV, then that price stays. For example if the IV of a stock is 100 but its current market price is 85, then the stock wont be in a hurry to jump to 100. It may happen gradually over few trading sessions. You will be in a comfortable position to grab that stock at attractive valuation.

Hello Karthik,

Why intangible assets cost is not considered in calculating FCF?

Thanks and Regards,

Ravi

Ah! I’m guessing its because FCF considers only cash expense towards current and real assets. I’ll have to do some research myself. Thanks for asking this question.

Respected Sir,

Thanks a lot for educating all of us. I have a confusion. I performed the DCF for Akzo Nobel and the price band came around 2000-2500. Current price is around 1800, that is below the lower band which somewhat signifies that the stock is undervalued. While, the PE ratio of the stock is 35 which means the price is too much according to its earnings. What should we as an investor interpret in such a situation?

Hmm, assuming you’ve done it right, then it suggests that the stock is undervalued. However, PE has nothing to do with this. It could be that the undervalued price itself is trading at a higher multiple.

Thank You so much sir for your reply. Just a clarification. According to the DCF the stock seems to be undervalued but according to the PE, the valuations seems expensive as we usually don’t buy stocks above the PE of 30.

If you are confident about DCF value, then you should go with it I guess 🙂

hi ,

i was going through intrinsic value calculation method. i have a follow up question

in today’s scenario should i consider 7 percent as discount rate(since you considered 9% in 2014-15??

No harm is being a little conservative. I’d still stick with 9%.

is this method universal for all kinds of companies like service companies , news paper, banks etc..

For them what is actual capital expenditure (considering their fixed assets are very less).

i calculated intrinsic value for sandesh(a gujrati news bulletin ) and it looks very undervalued ..

Yes, but do not apply this to banks and NBFCs.

Is there any method available for intrinsic value calculation for banks,NBFCs..

You can use a modified version of DCF….however, I dont know much about it.

What growth rate and terminal growth rate should i take into calculation ?

Its best if you keep the numbers very conservative. This also depends on the the industry/sector and the growth stage the company is in.

Hi,

Just wanted to ask. When there are different types of share class like in Tata Motors, which share class’s no of shares outstanding should i take.

Suggest you stick to the regular EQ class.

Hi Karthik,

Thanks for the excellent chapter.

I was calculating the share value Coal India using the method described and got a value of around 550.

As the share is currently selling around 250, will you consider it as a good buying opportunity.

Please let me know your thoughts

If you have done it right, then probably its massively undervalued. You may want to double check all the variables before buying it. Good luck.

Thanks

I did it using the consolidated statements in coal India annual reports

Yup, you should be working with consolidated statements.

As told earlier u have explained everything in great detail, thanx a lot for the same. I only have one doubt, I have downloaded the excel sheet given at the end, in that sheet- u have divided the total share capital with face value so as to find out number of shares. Can u pl explain me why u have done so, till now I was thinking that share capital= total no of shares .M I wrong?

Share capital is the total nominal Rupee value of the outstanding shares ….for example if I have 10 shares worth 1000, then in a crude sense, share capital is 10000 and number of shares is 10.

So u mean to say is to get the total number of shares I need to divide share capital by face value eachtime ….Right?

Yes Sir.

Sir calculation of free cash flow made here is done with annual report .But most of the companies for eg Amara Raja didn’t come up with annual report of 2017.

How can we calculate free cash flow using statement of audited financial results published after quarter on bse.

If possible then please let me know the formula.

Thanks a lot for educating us.

I think the AR is available. CF / BS is not published quarterly. Till you get the latest data, you have to depend on the previous year’s numbers.

Please suggest the site from where i can get the Annual report with full bifurcation of listed companies?

What exactly do you mean by full bifurcation?

i am using moneycontrol site .

I this site they give investing Activity but they do not give the bifurcation of the investing activity like purchase of tangible fixed assets etc

i.e they do not give full bifurcation of the header

so for comparing the different data in the P/L statement, balance sheet and cash flow statement which site you refer?

In fact, you should look at the Annual Report for data. That is the cleanest source of data.

Hello, Karthik! Thank you for a splendid article on Equity Research. I would appreciate it if you could shed some light on the cost of debt. How should one calculate it in an Indian scenario? What if the company is not paying any interest or is debt free? Is it in any way related to the Government bonds? If so, what should be an ideal spread for it?

Cost of debt really depends on the company and the kind of realtion/reputation it has in the debt market. Ideally for a well managed company, the cost of debt (under current economic scenario) should be around 9-10%.

All right. But how can I estimate that 9-10% on my own? Do I look at the financial statements? Or is there a website/journal which updates the Cost of Debt figures for the firms? I would be glad if you could direct me to any website or written material on this subject.

You will have the make this assessment yourself. This varies according to to the company you are dealing with…which further depends on the industry it belongs to.

Hi,

Please suggest that how can i download this Fundamental Analysis PDF file, i am unable to download it.

Thanks,

Ashutosh