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This blog post is intended to explain the basics of Discounted Cash flow valuation technique. I have used the technique to value all the stocks that I am following.
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Two main parts of DCF valuation
The total value of any business can be split into two parts: 1. Management’s ability to use all the assets in order to generate free cash flow. Here we estimate the future cash flow and discount them to present Value. 2. Net Fair value of assets – liabilities . Over here we donot count the assets that are directly used to generate FREE Cash, if we do it will be double counting (This concept will be explained later) EXAMPLE : Let us assume that we are finding a valuation for a business called “SUNNY TRUCKING co”. The company has around 50 trucks valued at $3 million. ASSETS
1. Cash and cash equivalents : $2 million. LIABILITIES
1. Short term debt : $0.2 million. TOTAL LIABILITIES : $1 million Business generates $1mn free cash every year (Net Cash generated by the business – Capital expenditure ). The company specializes in transporting hazardous chemicals. It’s a niche business and the company has built an expertise around it, thus its able to generate healthy cash flow. We estimate that it will be in the business for next 25 years and it will generate $1mn free cash every year. Assuming a discount rate of 5%, the sum of discounted cash flow for next 25 years = $14.45millions.
Value of the business is = A + B = $14.45 million + $1 million = $15.45 million
From the above example we can see that the base FCF (Free cash flow) was $1 million. Coming back to our original point as to why we don’t consider the fair value of the asset that produces FREE cash flow. In the above example the company generates free cash while deploying its Fleet of truck, thus the fair value of trucks is already reflected in the free cash flow and hence we don’t want to double count. But the net cash (Total cash – Total liabilities ) is for the owners to keep. In other words if you were to acquire the business , then you could use the cash to pay of all the debt and will still have $1 million left that you could use for any other purpose, hence this adds value to the business. Let us assume that the Trucking business also owned a piece of land that it once had bought with the intention of making a Garage. The land is sitting idle and is not used for the company’s business. If we assume that the fair value of land is $0.2 million. This can certainly be added to the value of the business , because the owner can any time sell the land and use the cash proceeds for its core business. “BLUE LIGHT TRUCKING” is a competitor. Its Financials are identical to that of SUNNY , except , the company has $1 million long term debt as compared to $0.5 million. The hot shot analysts of Wall St will give equal valuation for both companies , because their earnings are identical. But in reality , BLUE LIGHT TRUCKING’s value should be $0.5 million less than that of SUNNY TRUCKING because of the additional $0.5 million debt. This is the main reason one needs to pay very close attention to the Balance sheet before analyzing any other financial statement. WHAT IS DISCOUNT RATE? Discount rate is the sum of Risk Free rate and the Risk premium. If the business is more risky then the Risk premium is higher. Why do we need to Discount the Cash flows???...Let us assume that you have an offer to invest $1,000 in a business. You can either invest $1,000 in that business or put the money in a Risk Free investment like Treasury bills. Assuming the T-bills give 2.5% interest, then by investing in the business we are foregoing 2.5% interest compounded annually. Thus while calculating the returns, we need to deduct this loss. In the above Trucking business , we assumed a discount rate of 5%, hence the risk premium was 2.5% = 5% - 2.5% (Assuming 2.5% risk free rate) this reflects the uncertainty on our estimate of the future cash flow. As the time period increases , the discount factor also increases. Just think logically. If I give you a choice of taking in $1000 now or $100,000 in 50 years. I am sure you would opt for the first choice , because no matter what’s the premium , its not worth waiting 50 years. But un-fortunately common investors are totally fine making this decision when its comes to publicly traded stocks. I will cover some CASE STUDIES later in the blog that will showcase some ridiculous valuations by the street. A RISK FREE RETURN IS DEPENDENT ON A TYPE OF INVESTOR AND YOUR COUNTRY This might sound very weird, because in the text books risk free return is always considered the USA Treasury T-Bills. The following example might explain this concept. An individual investor in India with a net capital of Rs 10 lakhs (Rs 1,000,000 around $16,129 assuming conversion ratio of 1USD = Rs 62.00) is trying to come-up with an investment strategy to put his money to work. The safest option where he can get maximum return is a 1 year fixed deposit with State Bank of India. As of Mar-15-2014, 1 year fixed deposit rate was 9%. Practically speaking 9% is the risk-free interest rate for this investor, because if State Bank of India (considered to be safest bank of the country) defaults in its payments then one can assume that no other investment will be safe in India because the country would have to be in full chaos for State Bank of India to default. Thus if this investor is looking for investment avenues in the Equities market then his required rate of return needs to be much higher than that of 9%. If you have any doubts on this concept then please e-mail me : valuationtrg at gmail.com |
