DISCOUNTED CASH FLOW(DCF)
VALUATION IS THE ONE THING PEOPLE ARE MOST EXCITED ABOUT. THE VALUE OF A BUSINESS. MAYBE BECAUSE it's VERY MATHEMATICAL AND STRAIGHT FORWARD. BUT CALCULATING BUSINESS/STOCK VALUE IS NOT WHAT MAKES WARREN BUFFETT AND OTHER INVESTOR SUCCESSFUL. MOHNISH PABRAI SAYS "YOU SHOULD NOT HAVE TO USE EXCEL TO MAKE INVESTING DECISIONS.". BUT THAT'S PABRAI, ON THE OTHER HAND, WE AS NOVICE USUALLY HAVE AN URGE OR CURIOSITY TO UNDERSTAND HOW VALUATION WORKS.
IN THIS POST I WILL TALK ABOUT DISCOUNTED CASH FLOW(DCF) METHOD. BUT FIRST, let's WATCH A VIDEO OF WARREN BUFFETT TO UNDERSTAND THE BASIC IDEA:
What Is Discounted Cash Flow(DCF)?
IN THIS VIDEO WARREN BUFFET TALKS ABOUT HOW A BOND HAS ALL THE INFORMATION ON IT BUT WE HAVE TO FIND OUT THAT INFORMATION FOR A STOCK. DISCOUNTED CASH FLOW(DCF) METHOD IS A VALUATION METHOD WHERE A STOCK IS TREATED AS A BOND EXCEPT THAT THE VALUE OF THIS BOND GROWS EACH YEAR.
LET ME GIVE YOU BASIC STEPS OF DISCOUNTED CASH FLOW.
- WE TAKE THE BUSINESS FREE CASH FLOW.
- WE GROW IT AT AN APPROPRIATE GROWTH RATE AND DISCOUNT THE CASH FOR EACH YEAR.
- WE CALCULATE THE TERMINAL CASH FLOW AND DISCOUNT IT.
- WE ADD IT ALL UP AND DIVIDE BY TOTAL NO OF SHARE IN A COMPANY.
AND THAT'S IT YOUR DONE! OK MAYBE NOT. Let's TAKE IT ONE BY ONE AND TALK ABOUT ALL THE POINTS. Let's FIRST GET AN IDEA OF FEW IMPORTANT TERMS.
1. CASH FLOW
THIS IS THE FREE CASH FLOW OF THE BUSINESS, THE MONEY LEFT FROM NET INCOME AFTER PAYING FOR ALL BUSINESS OPERATION AND IS USUALLY FOUND IN THE CASH FLOW STATEMENT OF A BUSINESS.
2. GROWTH RATE
THIS IS THE GROWTH WE EXPECT A BUSINESS TO GROW.
3. DISCOUNT RATE
THIS IS THE MOST CONFUSING. IF SOMEONE TELLS YOU THAT A COMPANY IS WORTH 100 MILLION $, THE FIRST THING YOU MUST ASK IS AT WHAT DISCOUNT RATE. JUST AS WARREN BUFFETT SAID IN THE VIDEO THE POINT OF INVESTING IS TO PUT MONEY NOW TO GET MORE MONEY IN THE FUTURE. THIS IS WHERE DISCOUNT RATE COMES IN. WE CALCULATE HOW MUCH WE SHOULD PAY NOW TO GET A PARTICULAR AMOUNT LATER. WE WILL SEE NEXT IN DETAIL.
4. TERMINAL CASH
THIS IS AN ESTIMATION OF THE CASH FLOW A BUSINESS CAN GENERATE FOR ITS ENTIRE LIFE ASSUMING THE BUSINESS GROWS AT A CONSERVATIVE RATE. YOU MULTIPLY THE CASH FLOW OF THE TERMINAL YEAR(10YR IN THIS CASE) BY TERMINAL MULTIPLE.
OK, let's TAKE A EXAMPLE BUSINESS.
1.CASH FLOW = 10 MILLION $
2.GROWTH RATE = 15% PER YEAR
3.DISCOUNT RATE = 10 %
1ST STEP:
FIRST YOU CALCULATE THE GROWTH FACTORS AND DISCOUNT FACTORS FOR 10 YEARS. THE GROWTH FACTOR OR GROWTH MULTIPLE IS THE MULTIPLE AT WHICH INITIAL CASH GROWS. FOR EXAMPLE, THE CASH AFTER 1 YEAR OF INVESTMENT AT 15% RETURN GROWS BY:
CASH(AFTER 1YR)=INITIAL CASH FLOW+15% OF INITIAL CASH FLOW
CASH(AFTER 1 YR)=INITIAL CASH FLOW*(1+15%)
CASH(AFTER 1 YR)=INITIAL CASH FLOW*(1+0.15)
(1+0.15) = 1.15 IS THE GROWTH MULTIPLE FOR 1ST YEAR. FOR THE SECOND YEAR, CASH(AFTER 1 YR) WILL GROW FURTHER BY MULTIPLE OF 1.15.
CASH(AFTER 2 YR)=CASH FLOW(AFTER 1 YR)*(1.15)
CASH(AFTER 2 YR)=INITIAL CASH FLOW*(1.15)*(1.15)
CASH(AFTER 2 YR)=INITIAL CASH FLOW*(1+0.15)2
CASH*(1+0.15)2
= 1.32 IS THE GROWTH MULTIPLE FOR 2ND YEAR. IN GENERAL THE GROWTH MULTIPLE AFTER ANY NO OF YEARS IS GIVEN BY:
GROWTH FACTOR = (1+GROWTH RATE)YEARS
FOR EXAMPLE,
GROWTH FACTOR(15% FOR 6TH YEAR) =(1+0.15) 6
SIMILARLY, THE DISCOUNT FACTOR OR DISCOUNT MULTIPLE IS CALCULATED.
DISCOUNT FACTOR = (1+DISCOUNT RATE)YEAR
FOR EXAMPLE,
DISCOUNT FACTOR(10% FOR 3RD YEAR)=(1+0.10) 3
YOU HAVE TO CALCULATE GROWTH FACTOR AND DISCOUNT FACTOR FOR EACH YEAR.
NOTE:
DIFFERENCE BETWEEN GROWTH FACTOR AND DISCOUNT FACTOR?
THE GROWTH FACTOR TELLS YOU THE FUTURE CASH FLOW BASED ON INITIAL CASH AND A GIVEN GROWTH RATE. THE DISCOUNT FACTOR, ON THE OTHER HAND, TELLS THE INITIAL CASH REQUIRED TO MAKE A PARTICULAR RATE OF RETURN ON EXPECTED FUTURE CASH. THE DETAILS OF HOW TO USE DISCOUNT FACTOR IS IN 3RD STEP.
BELOW IS A TABLE OF ALL THE FACTORS
NEXT STEP IS WHERE YOU GROW THE CASH FLOW EACH YEAR AT APPROPRIATE GROWTH RATE. FOR THIS YOU JUST NEED TO MULTIPLY THE CASH BY GROWTH FACTOR OF THAT PARTICULAR YEAR.
FOR EXAMPLE,
TO GET FUTURE CASH FLOW OF 7TH YEAR, YOU TAKE 7TH YEARS GROWTH FACTOR 2.66 AND MULTIPLY THIS BY INITIAL CASH FLOW.
CASH(YEAR 7) =2.66*(CASH FLOW INITIAL)
THIS IS THE AMOUNT OF CASH THE BUSINESS GENERATES IN THE 7 TH YEAR ACCORDING TO OUR PROJECTIONS. DO THIS FOR ALL 10 YEARS TO GET CASH PROJECTIONS OF THE BUSINESS.
BELOW IS THE TABLE FOR 100 MILLION INITIAL CASH FLOW
THE NEXT STEP IS TO DISCOUNT THE CASH FOR EACH YEAR TO THE PROPER DISCOUNT. FOR THIS YOU DIVIDE THE CASH FLOW FOR A PARTICULAR YEAR BY THAT YEARS DISCOUNT FACTOR. FOR EXAMPLE IN ABOVE TABLE WE GET 175 MILLION FOR 4TH YEAR, WE DISCOUNT IT BY DIVIDING THIS BY TAKING THE 4TH YEARS DISCOUNT FACTOR 1.46 TO GET DISCOUNTED CASH FLOW FOR THAT YEAR.
DISCOUNTED CASH FLOW(YEAR 4) = (175 / 1.46) = 120
THIS MEANS THAT IF THE BUSINESS GENERATES $175 MILLION, TO GET 10% RETURN YOU CAN PAY $120 MILLION CASH INITIALLY. AND THIS IS WHY DISCOUNT RATE IS IMPORTANT. SINCE YOU DON'T WANT TO PAY 10$ NOW TO GET 10$ LATER, NO YOU WISH TO PAY LESS NOW TO GET PAID MORE LATER.
NOTICE THAT IF YOU PAY LESS THAN 120 MILLION YOU GET HIGHER RATE OF RETURN AND IF YOU PAY MORE 120 MILLION YOU GET LOWER RATE.
DO THIS DISCOUNTED FOR EACH YEAR.
4TH STEP:
THE NEXT STEP IS TO CALCULATE THE TERMINAL CASH FLOW. FOR THIS YOU TAKE THE FINAL YEAR CASH FLOW AND MULTIPLY BY TERMINAL MULTIPLE.
NOTE:
WHAT IS TERMINAL MULTIPLE?
THIS IS WHERE YOU MUST USE YOUR ANALYSIS AND UNDERSTANDING OF A BUSINESS. IF YOU HAVE A GOOD BUSINESS THAT PRODUCES GOOD CASH FLOW AND GROWING AT DECENT GROWTH RATE OF 8-12% YOU CAN EASILY USE TERMINAL MULTIPLE OF 10 TO 15.
IF YOU ARE UNSURE USE 10 TO BE SAFE, AND IF YOU ARE CONFIDENT IN THE BUSINESS YOU CAN USE 15. YOU MAY ALSO USE MULTIPLE OF ABOVE 15 LIKE 20 FOR A TRULY WONDERFUL BUSINESS.
I WILL BE USING TERMINAL MULTIPLE OF 15.
TERMINAL CASH FLOW = TERMINAL MULTIPLE*CASH FLOW OF 10TH YEAR
AFTER THIS YOU HAVE TO DISCOUNT THE TERMINAL CASH FLOW BY DIVIDING IT BY 10 YEAR DISCOUNT FACTOR.
DISCOUNTED TERMINAL CASH FLOW = TERMINAL CASH FLOW
DISCOUNT FACTOR(10 YR)
THE NEXT STEP IS TO ADD ALL OF THE DISCOUNTED CASH FLOW OF 10 YR AS WELL AS THE DISCOUNTED TERMINAL CASH FLOW. ADDING THIS WILL GIVE US TOTAL INTRINSIC VALUE OF THE BUSINESS.
YOU CAN GET THE INTRINSIC VALUE OF THE STOCK BY DIVIDING TOTAL CASH BY TOTAL NO OF SHARES.
BELOW IS THE TABLE FOR OUR EARLIER EXAMPLE:
ACCORDING TO THIS TABLE A BUSINESS WITH 100 MILLION $ CASH FLOW, GROWING AT 15 % A YEAR BOUGHT AT 3600 MILLION WILL GIVE 10 % RETURN. WHILE THE INTRINSIC VALUE OF STOCK IS 360 $.
THIS IS ONE OF THE WAYS YOU CAN VALUE A BUSINESS. YOU CAN CHANGE THIS TO YOUR LIKING IN EXCEL. FOR EXAMPLE, YOU CAN HAVE DIFFERENT GROWTH FOR 1-5 YEAR AND DIFFERENT FOR 5-10 YEAR, OR YOU CAN USE PERPETUITY CASH FLOW INSTEAD OF TERMINAL CASH FLOW. BUT THIS IS THE GENERAL CONCEPT OF DCF VALUATION METHOD.
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