Company Analysis 3: Valuation Part 2

DCF Valuation Real Business Example

Now that we have come a long way in the journey of understanding fundamental analysis. It is the right time to get into a real example of the intrinsic value calculation. Before that let me list out the steps in the calculation process.

1. Find Current Free Cash Flow
2. Identify the Cash Flow Growth Rate
3. Estimate Future Free Cash Flow
4. Find the Terminal Value
5. Find Net Present Value
6. Find Fair Price of Share

In the above-listed steps, we have discussed all steps except the fourth step of finding terminal value in 'Quantitative analysis for valuation part 1'. So now we will first discuss the terminal value and then start with the calculations.   

Terminal Value

If you remember the agricultural land example you must also remember that we had calculated value for 10 years lease and not for buying. Didn't you find it odd? Now when I will tell you dynamics behind it then you will understand what a terminal value is.

In that example, we valued a land, the produce from the land more or less remain constant if we take care of land well. But in the case of the company, the growth of the company does not remain constant throughout its lifecycle. In the first few years grow well but free cash flows are mostly negative because of investment in the growth of the company. This is the initial stage of the company. In the next cycle, the company starts producing free cash flows and keeps them growing at a fine rate. After that, a third cycle comes when the company's growth in producing free cash flow reduces. This is called the saturation stage. In this stage, though the company is not growing free cash flows at a high rate it keeps producing a high amount of free cash that it can either pay us as dividends or invest to buy new ventures, and hence this cash flow cannot be neglected. Calculating this cash flow is a hard task as this situation may arrive after 10 years which is a long time to predict. Hence a terminal value concept was introduced to compensate for cash flows after 10 years.

The terminal value can be calculated by following formulae.

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

It is a standard practice to use a terminal growth rate of less than 5 more specifically 3 or 4.

FCF is Average Free Cash Flow (Most people use 3 years average.) 

The current average Fixed Deposit rate or your expected CAGR can be used as Discount Rate.

Let us now get straight into a real example for better understanding. 

Calculations:

The screenshot shared below is the cash flow statement of CESC Ltd. as seen in data platform tickertape.in

• Find Current Free Cash Flow: 

1. The current free cash flow can be directly seen from the cash flow statement shared above but it is general practice to take an average of the last 3 years as a current free cash flow to compensate for any major one-time expense that may have occurred during year under review.
2. Hence, Current Free Cash Flow = (1574.15+1456.08+2256.92)/3 = 1762.38 Cr.

• Identify the Cash Flow Growth Rate:

1. Now, this is tricky as you have to select a reasonable percentage at which the cash flows should be growing. I personally like to go with two different numbers one for the next 5 years and another for later 5 years. 
2. For the next 5 years, a number between 10-20% can be selected while for later 5 years between 5-10%.
3. For this example let us assume 15% and 10%.

• Estimate Future Free Cash Flow:

1. Based on the assumption of cash flow growth rates future cash flows can be calculated as FCF for next year = FCF for this year * (1+Growth rate)
2. FCF for FY2021 = Average FCF * (1+first five years growth rate) = 1762.38 * (1+15/100) = 2026.74 Cr.
3. FCF for  FY2022 = 2026.74*(1+15/100) = 2330.75 Cr.
4. Similarly, Cash flows for FY2021 to FY2030 are shown in the table 
   

• Find the Terminal Value

1. Terminal Value = FCF * (1+Terminal Growth Rate) / (Discount Rate - Terminal Growth Rate)
2. Assuming the terminal growth rate at 3%, Discount Rate at 7%, and FCF as FCF for 10th year that is 5708.90
3. Terminal Value = 5708.90 *(1+3%) / (7%-3%) = 147004.17 Cr 

• Find Net Present Values

1. Net Present Value = Future Value/(1+Discount Rate)^(number of years)
2. Net present Value of FCF for FY 2021 = 2026.74/(1+7%)^1 = 1894.15 Cr.
3. Net present Value of FCF for FY 2022 = 2330.75/(1+7%)^2 = 2035.77 Cr.
4. Similarly, Net Present Values of all future cash flows are calculated as shown in the table below.
   
    
5. Net Present Value of Terminal Value = Terminal Value/(1+Discount Rate)^10 = 74729.46 Cr
6. Net Present Value of Total Future Cash flow = 24737.19 + 74729.46 = 99456.65 Cr

• Find Fair Price of Share

1. Now fair price of a share = (Present Value of future Cash flow + Current Cash - Debenture)/Total Number of Shares 
2. Fair Price = (99456.65 + 1805.97 - 9770.11)Cr/132557043 = 91492.51 Cr/132557043 = 6902.1 Rs

• Limitations of the DCF Model:

1. Don't you find fair value to be too high compared to the market price the reason here is, the rate of cash flow growth we assumed to be 15% for the next 5 years and 10% for later 5 years is too high, for this company. 
2. There are too many assumptions and no specific guidelines on choosing the right ones.
3. This makes the DCF model vulnerable to mistakes and that is why another factor called modeling error/factor of safety is introduced where we divide the price by safety factor that ensures buying at discount to fair value.

• Recommendation:
• I recommend you to assume the following values to calculate fair value of this company:

1. Discount Rate 12%
2. Growth Rate First 5 years 10%
3. Growth Rate next 5 years 5%
4. Terminal Rate 2% - 3%
5. The margin of Safety 25% - 50%

• I made the mistakes knowingly so you can understand how this model can manipulate your emotions. I have seen people changing values to match the current market price which is a totally wrong process.
• Either do a good amount of research before starting to invest so that you can understand what values should be assumed as different companies require different assumptions.
• Or use a valuation model that is free of assumption.
• I have chosen to use an assumption-free valuation model which I will discuss in next article.

Disclaimer: 

• The valuation of the company is calculated for educational purposes only and it should not be taken as investment advice.
• I may have invested interest in the company.