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HOMEPERSONAL FINANCEINVESTMENTDiscounted Cash Flow (DCF): How to use DCF
Method for Stock Valuation? [Calculator]

Discounted Cash Flow (DCF):

How to use DCF Method for
Stock Valuation? [Calculator]
What is Discounted Cash Flow (DCF)
valuation? Which are the steps to do DCF
Analysis? How to calculate intrinsic value
using DCF?
MANI[sh] Investment 5

Discounted cash flow (DCF) is of the more accurate financial models

used to estimate intrinsic value of stocks. This method of stock’s price
valuation is used by experts like Warren Buffett etc.
What makes discounted cash flow (DCF) model more accurate? It is
the metrics that this financial model uses makes its estimates more
accurate.

Two unique metrics that is used in DCF is free cash flow

(FCF) and Weighted Average Cost of Capital (WACC). We will see
more about these later. Before that, let’s discuss the process of DCF
analysis.

PROCESS OF DISCOUNTED CASH

FLOW (DCF)
Before we go into the calculation part of DCF, allow me to explain the
process in brief. It will help you to get an overall feel of DCF analysis
in totality.
1. FCF (Past): DCF process starts with calculation of free cash flow (FCF)
of past 5 years. As FCF is not directly reported in company’s financial
reports, hence it needs to be separately calculated by the investors. I’ve
written a separate article on free cash flow calculation. You shall read it
before proceeding with DCF calculations.
  (1.a) FCF Growth (Past): Once past 5 year’s FCF is calculated,
these values must be used to calculate the FCF growth rate (CAGR)
shown by the stock in the past. How to calculate.
 (1.b) FCF Growth (Future): Based on the past 5 years FCF
CAGR, an assumption shall be made for future growth rate
(CAGR). This growth rate will say at what average rate the FCF will
grow in next 5 years. How to calculate.
2. FCF (Future): In #1 we will get the current year’s FCF. In #1.b we will
get FCF growth rate for future 5 years. Using these two numbers, we will
calculate the FCF for next 5 years ahead in future.
3. Terminal Value (TV): We are assuming FCF for only next 5 years. But
the company will continue to generate FCF after 5th year as well. Hence,
for beyond 5th years, all FCF’s generated by company is called terminal
value. This must be calculated using a TV formula.
 (3.a) TV Growth Rate: To calculate TV, a suitable growth rate
must be assumed first. Consider this growth rate as a rate at which
the company’s FCF will grow beyond the 5th year in future.
 (3.b) WACC: We must also calculate the Weighted Average
Cost of Capital (WACC) for the company. WACC will work as a
“discounting rate” to calculate present value of future FCF’s & TV.
4. Present Value (PV): All future FCF’s & TV must be suitably
discounted to calculate their present value. Sum of all present values of
future FCF’s will give the intrinsic value.
DCF Calculator

STEPS OF DCF ANALYSIS

What we have seen above is only a small description of the process of
Discounted Cash Flow (DCF). Now we will see more details. We will
actually go ahead and do a DCF analysis for a stock.

1. FREE CASH FLOW (OF PAST 5 YEARS)

Free Cash Flow (FCF) is an improved version of net profit (PAT).
What is easily available in company’s financial statement is PAT. But
FCF must be separately calculated by the investors. Warren Buffett
mentions Free Cash Flow as “Owners Income”. It was Buffett who
made the use of Free Cash Flow popular for stock analysis.

FCF Calculator
To practice Discounted Cash Flow (DCF) analysis on stocks more
successfully, correct estimation of company’s future free cash flow is
important. Read:  How to estimate free cash flow.

(1.A) FCF GROWTH RATE (PAST)

Once the FCF’s of last 5 years is calculated, the next step is to calculate
its annualised growth rate (CAGR). Calculation of CAGR is simple. I
will show you how it can be done in Excel using RRI function. Check
the below screen shot for details. The excel formula for CAGR is
=RRI(nper, pv, fv)

(1.B) FCF GROWTH RATE (FUTURE)

Based on the growth rate at which the FCF grew in last 5 years, we can
assume that FCF will grow at the same rate in next 5 years in future.
Hence, in the example considered, FCF growth rate for future will
be 5.952% (CAGR) for next 5 years.

In case the analyst is not confident about the past growth rate being
imitated in future, a suitable correction factor can be considered.
Suppose the analyst in only 75% sure, in this case the adjusted growth
rate will be 4.46% (=75% x 5.92%).

For example sake, let’s consider the correction factor of 100% and
proceed with our calculations.
2. FREE CASH FLOW (FUTURE)

In Step #1 and #1.b, we have got two critical numbers. First, free cash
flow of current year (as on Mar’19). Second is expected free cash flow
growth rate (CAGR) for next five years.
 FCF (Mar’19): Rs.15,985 Crore.
 FCF Growth (next 5 years): 5.952%.

We will use these two numbers to extrapolate and forecast an expected

FCF for next 5 years. Let’s see how the future FCF numbers looks in
excel.

Example:
 FCF (31-Mar-21) = FCF (31-Mar-20) * (1+FCF Growth Rate).
 FCF (31-Mar-21) = 16.937 * (1+5.952%) = 17,945
3. TERMINAL VALUE (TV)

To calculate terminal value, we will use the FCF of 5th year (31-Mar-
24) as shown in the above example (Rs.21,344 Crore). This will work
as a base year for all future cash flow which this company will ever
generate (called terminal value).

But to calculate TV we will need two more number: (a) TV growth

rate, and (b) WACC.
The formula for terminal value is, TV = FCF / (WACC – Growth
Rate). Let’s see how Terminal Value (TV) numbers looks in excel. In
this case the terminal value will be: TV = 21,344 / (9.11% – 3.5%) =
3,80,461.

(3.A) TV GROWTH RATE (EXPECTED)

TV growth rate can be assumed to be at leat 3.5% per annum. I’ve

intentionally kept the number so low. This gives us a more conservative
intrinsic value figure.

[P.Note: The lower is the TV growth rate, smaller will be the intrinsic
value.]

(3.B) WEIGHTED AVERAGE COST OF CAPITAL (WACC)

What is WACC? Check here. The Excel working of WACC will look

like this:
 WACC = Cost of Equity + Cost of Debt.
 WACC = E/(E+D) x Ce + D/(E+D) x Cd.
  Risk Free Rate (Rf): The yield of 10 year government bond can be used
as risk free rate (Current Rf).
 Stock Beta (B): It is a measure of stock’s price volatility with respect to
the benchmark index (Nifty, Sensex, BSE 500 etc). You can get any
stock’s beta from economictimes.
 Risk Premium (Rp): This is the investors expected returns over and
above the risk free free rate. For example I’ve assumed it as 6%.
 Pre-tax cost of debt (Cpt): This is the interest rate that a lender charges
for loan in general to the company. I’ve assumed here that, the company
is paying an interest of 8.2% (1.5% above Rf) on its loans.
 Effective Tax Rate (Tr): All companies need to pay tax to government
on its profit. Effective tax rate (Tr) is the average income tax paid but the
company on its profits. For example I’ve assumed it as 25%.
 Total Equity (E): This number will be available in company’s balance
sheet. Sum of share capital and reserves is the total equity.
 Total Debt (D): This value is also available in company’s balance sheet.
Sum of all long term and short term borrowings will account for the total
debt of the company. Read: debt free companies.

3. PRESENT VALUE (PV)

In this step, one must calculate the present value of all future cash
flows. Which are the future cash flows? FCF for next 5 years
(calculated in #2) and terminal value (calculated in #3).

To calculate present value, all the above 6 cash flows needs to be

suitably discounted. What will be the discounting factor? WACC
(calculated in #3.b).

Formula: PV = FCF / (1+WACC)^(N).

 FCF: Free cash flow or terminal value (say 20,145).
 WACC: Weighted Average Cost of Capital (say 9.11%).
 N: Number of years ahead in future (say 4 Years)
 PV: Present Value (=20,145/(1+9.11%)^4 = 14,214).

Let’s see how the whole calculated of present value calculation looks in
excel:

Total Present Value (PV) of all future cash flows in this example
is Rs.2,98,737 Crore.

INTRINSIC VALUE
Now that we have calculated the Present value of all future cash flows
of the company, how to check if it is undervalued or overvalued?

To do this check we’ll need to do some more calculations. We will

have to convert the present value number to present value per share
(PVPS). How to do it? By use of the below formula: PVPS = Total
PV / No of shares outstanding.

Once PVPS is calculated this becomes the intrinsic value per share.

Now we can compare intrinsic value with the current price of the share.
If the current price is less than intrinsic value, the stock
is undervalued. If current price more than intrinsic value, the stock is
overvalued.

CONCEPT OF MARGIN OF SAFETY

The accuracy of the calculated intrinsic value is dependent on two main
factors, (1) On the estimated future cash flows, and (2) on the
calculated WACC.

In case an investor is 100% confident of his calculation of these two

numbers, he/she apply a multiplying factor of one (1) on the calculated
intrinsic value.
In case the confidence is not so high, using a suitable multiplication
factor is advisable. I generally use a multiplication factor of 2/3rd
(0.667) on my estimates.

I first apply the multiplication factor on the calculated intrinsic value

and then compare it with current price to judge if the stock is
undervalued or not.

CONCLUSION
Calculation of intrinsic value of stocks using DCF model is not easy for
all. But this is also true that DCF method is one of best ways to
estimate intrinsic value of stocks.

But as you have seen, estimating intrinsic value using DCF involves
several steps. Moreover, it also needs a deeper understanding of
companies financial reports.

The procedure is like fool proof but it has its own limitation. Often the
limitation is on the side of the investor’s understanding of the numbers
in the financial reports.

I have a developed a model for myself. I call it My stock analysis

worksheet. This worksheet can estimate intrinsic value of stocks based
on DCF and other methods.

Stock Analysis Worksheet

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5 COMMENTS

1. Avinash Ainapure says:
13-06-2020 AT 3:21 AM
Good Work

REPLY

o MANI[sh] says:
13-06-2020 AT 7:00 AM

Thanks

REPLY

2. Dinesh T says:
01-05-2020 AT 5:16 PM
Thank you very much for the article sir. It is really helpful.
I could not understand the Terminal value assumption alone. Can we consider TV =3.5%
to find intrinsic value of all stocks?

REPLY

o MANI[sh] says:
01-05-2020 AT 5:39 PM

Yes that is what I assume for companies in general. Though a higher value
can be assumed, but for terminal value, it is better to be conservative.
Depending upon how well we know about the company, a higher or lower
growth number can be assumed.

REPLY

3. Sk Abdul Karim says:
19-02-2020 AT 9:34 AM
Respected sir, You are genius.
Your fundamental principles and articles on stock analysis is awesome.
Your blog is a guide of investment for novice people like me.
I want to buy your basket of 10 products. Please guide me ..

Thank you

REPLY

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