This article shall be your guide to DCF Primer and all the aspects about it. You will find a detailed explanation of DCF Valuation, following which you can reap the benefits it contains.
Lets get started on understanding this concept of Fundamental Analysis.
What is DCF Primer?
An investment is considered good only when it is done at the right price.
Equity research analysts say that, if you buy a profitable business at undervalued prices, then only you should call yourself a smart investor.
So, now the question arises, how to know the fair price of the stocks? In order to answer this, different people use different techniques and models.
However, the most popular one amongst them is the Discounting Cash flow model (DCF Model).
In this technique, perceived future cash flows of a company are discounted at a rate to understand their present value.
And then, this intrinsic value is compared with the market price of the sock in order to decide whether to buy or not.
It is essential to understand that the price at which you invest is one of the most crucial considerations. It is imperative to take correct entry in the market!
A discounted cash flow valuation is a technique used to find the net present value of future free cash flows.
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Know about DCF Valuation or DCF Model
There are several assumptions used to calculate this value. In order to understand the DCF Primer model, we first need to understand a few concepts related to it:
Free Cash Flows:
These are the amounts which the company is left with after paying off all operational and capital expenses.
Free cash flows= Cash from operating activities- Capital expenditures related to expansion/ diversification
The free cash flows are an essential indication of how the company is performing. However, there are chances that the company might inflate this value by selling off a lot of capital assets.
Thus, it is vital to have a closer look at the balance sheet before proceeding ahead.
It is also essential to take into account taxes while doing this calculation. The future values of the cash flows are calculated using an annual growth rate.
This rate is assumed based on the historical trends and performance of the company. Any wrong assumption can lead to adverse impacts.
These free cash flows of the future are discounted to get their present values. In order to achieve the future cash flows amount, the concept of the time value of money is given importance.
This is the annual rate at which the company is expected to grow in the coming 5-10 years. An investor must use realistic growth rates while doing the DCF analysis.
Otherwise, the intrinsic value derived would be wrong. The growth rates are usually estimated using historical growth rates of earning or profits. Some other investors use expert analysts’ predictions.
In comparison, the other way of finding the expected growth rate is to take a look at the company’s annual report and financial statements. There is no one fixed method of arriving at the growth rate figure.
However, the only factor that has to be kept in mind is that the growth rate should not be estimated without any definite criteria.
It is the annual return you expect to earn from your investment. This is usually calculated using the capital asset pricing model.
However, you can take any figure you want based on your expectation from the company. For example, if an investor wants a return of 10% per annum from his investment in a specific stock, he would take 10% as the discounting rate.
It can be defined as the sum of all future free cash flows, up to the terminal year. The terminal value can be calculated as:
Terminal value = FCF * (1+Terminal Growth Rate)/(Discount rate- Terminal growth rate)
Here, the terminal growth rate is the rate of growth of FCF beyond the terminal year.
The terminal value of a company is calculated, keeping in mind the “Going concern” principle. This assumption states that a business will continue to operate for a foreseeable period and continue generating FCF.
Time Value of Money:
The basic concept of the time value of money is that money’s worth does not remain constant over time.
The concept of the time value of money can be used, either way, that is, either to arrive at the future value or the present value.
Future value means the value of today’s money in later years, whereas, the present value means the value of the future’s money in today’s terms.
In the DCF analysis, the present value concept is used in order to arrive at the net present value of all future cash flows expected.
The discounting concept is put to use here. The discount rate can be calculated using the capital asset pricing model.
The other simpler alternative is to use the rate of return you are expecting from your investment as the discount rate.
For example, if an investor wishes to buy the stocks of a company, and he hopes to get a return of 15% after five years, he can use 15% as the discounting rate to get the net present value.
Net Present Value:
NPV is the sum total of present values of all the future free cash flows. The discounting rate used should be realistic.
This is because, if the discounting rate chosen is incorrect, the NPV will be wrong, which means the entire exercise of doing the DCF analysis will be futile.
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How to do DCF Primer Analysis?
Now that we have a brief understanding of the main concepts involved in the DCF Primer analysis, we can go ahead with understanding the process.
We will make use of some examples to understand each step better:
- Calculate the average of the last three years’ free cash flows.
- Multiply the above value with the growth rate to get the future value of free cash flows.
For example, suppose the average cash flows derived= INR 300 Crore. The assumed growth rate= 10%.
The future cash flow for the first year= 300(1.1) is INR 330 Crore.
For the next year= 330(1.1)= INR 363 Crore, and so on.
- Derive the present value of the future cash flows by dividing them with a suitable discounting rate.
- Add all the present values from beginning to a terminal year to arrive at the net present value.
- Calculate terminal value.
Terminal value= FCF * (1+Terminal Growth Rate)/(Discount rate- Terminal growth rate)
- Add the NPV calculated for “n” years to the terminal value. This would be equal to the discounted market capitalization value.
- Now, divide the market capitalization amount by the total number of outstanding shares. This would help you arrive at the intrinsic value of the share.
What are the benefits of DCF Primer or DHF Model
Here, we have listed out some of the advantages of DCF Primer –
- It takes into account the cash flows and not earning or profits, which makes it more trustworthy. This is based on the fact that it is harder to manipulate cash flows.
- It takes into account all major business assumptions to give a detailed view.
- It is easy to use and perform.
Disadvantages of the DCF Primer
Here are few disadvantages of DCF Model:
- Ignores the relative value of competitors and industry standards.
- Small changes in assumptions can lead to drastically different results. For example, if a different growth rate is used, the entire model would collapse.
DCF Primer – Conclusion
DCF Primer valuation model is an easy-to-use valuation technique to understand whether an investment should or should not be made.
If the intrinsic value arrived at by this analysis is less than the market value, then it should not be considered for investment.
However, when the intrinsic value is more than the market value, it means that the company is undervalued.
If the investor has a strong belief that the growth rate assumed in the valuation can be the actual rate, then he should go ahead with the investment.
A brief outlook about the overall industry performance should also be kept in mind. One should always remember that it is impossible to arrive at accurate values. Hence, the concept of an intrinsic value band can be used.
This would help the investor find a reasonable price range for investment. The DCF model is a widely used valuation model, but one should have the market expertise to make correct predictions.
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