Equity Research (Part 2)

15.1 – Getting started with the DCF Analysis

We discussed “The Net Present Value (NPV)” in the previous chapter. NPV plays a vital role in the DCF valuation model. Having understood this concept, we now need to understand a few other related topics to the 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 3rd stage of Equity Research, i.e. ‘The Valuation’.

In the previous chapter, to evaluate the pizza machine’s price, 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 with the idea –What will happen if the company’s stock replaces the pizza machine? In that case, we just need an estimate of the future cash flows from the company, and we will be able 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)

We need to consider the cash flow 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, free cash is the amount of cash the company is left with after paying all its expenses, including investments.

When the company has free cash flows, it indicates the company is healthy.  Hence investors often look out for 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

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? 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 will encourage you to go through the following step by step calculation for 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 accounting for the business’s cyclical nature. For example, in 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 2nd stage deals with the last 5 years. Specifically, concerning 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…

An estimate of future cash flow –

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 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 10th 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 that as long as the company exists, some amount of free cash is generated. However, as companies mature, the rate at which 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 10th year, also called the terminal year. To calculate the terminal value, we just have to take the cash flow of the 10th 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 10th 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 10th 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 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 a 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 –

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 totally 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 firm’s future free cash flow.

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 its 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 the 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 company’s share price, 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, we should assume (yet another assumption ) that we have made a few errors while making the intrinsic value calculation for all practical purposes. Hence, we should accommodate for modelling errors.

A leeway for the modelling error simply allows us to be flexible with calculating 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 stock’s intrinsic value.

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 stock’s fair value, 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 –

1. If the stock price is below the lower intrinsic value band, we consider the stock to be undervalued. Hence one should look at buying the stock.
2. 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 adding more to the existing positions.
3. 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.

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 are 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 the current market price. 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.

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 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 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 company’s performance. 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 stock’s intrinsic value and compare it with the market value. If the stock is trading cheaper than the intrinsic value, then it is considered a good buy. Else it is not.

When all the 3 stages align to your satisfaction, 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  this and use it as a calculator for other companies as well.

Key takeaways from this chapter

1. The free cash flow (FCF) for the company is calculated by deducting the capital expenditures from the net cash from operating activates.
2. The free cash flow tracks the money left over for the investors.
3. The latest year FCF is used to forecast the future year’s cash flow.
4. The growth rate at which the FCF is grown has to be conservative.
5. The terminal growth rate is when the company’s cash flow is supposed to grow beyond the terminal year.
6. The terminal value is the value of the company’s cash flow from the terminal year upto infinity.
7. The future cash flow, including the terminal value, has to be discounted back to today’s value.
8. The sum of all the discounted cash flows (including the terminal value) is the total net present value of cash flows.
9. 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.
10. One needs to accommodate for modelling errors by including a 10?nd around the share price.
11. By including a 10% leeway, we create an intrinsic value band.
12. Stock trading below the range is considered a good buy, while the stock price above the intrinsic value band is considered expensive.
13. Wealth is created by long term ownership of undervalued stocks.
14. Thus, the DCF analysis helps the investors identify whether the company’s current share price is justified.