Equity Research Part 2

Using DCF Analysis

In the previous chapter, we talked about Net Present Value (NPV). NPV plays a very important role in the DCF valuation model. Now we need to understand some more principles related to DCF model. We will apply the DCF model to Amara Raja Batteries Ltd and understand the underlying principles. By doing this we will also understand the third stage of equity research i.e. valuation method.

In the previous chapter, we tried to find out the cash flow based on the price of the pizza machine and after discounting it, we worked out the PV. We worked out the Net Present Value (NPV) by adding up all the present values. At the same time, we had also tried to think that if the same thing is applied to the stock of a company instead of a pizza machine, then what will be known? The truth is that by looking at the future cash flow of any company, we can find out the price of that share. But what cash flow are we talking about? How can we find the future cash flow of the company?

Free Cash Flow (FCF)

The cash flow we use in the company’s DCF analysis is called Free Cash Flow (FCF). It is the cash that is left with the company after its capital expenditure, such as purchase of land, house or machinery. This is the amount that is kept for the shareholders. The hallmark of a good business is the amount of free cash flow it is generating.

So free cash flow is the amount that the company is able to save after all its expenses and investments.

If the company has free cash, it means that the health of the company is good. That’s why investors are always on the lookout for companies that are priced low but have good free cash flow. They think that in the coming time, the gap between the share price and the cash flow will disappear and the share price will go up according to the good cash flow.

The formula to calculate free cash flow is:

FCF = Cash from business – Capital expenditure

FCF = Cash from Operating Activities – Capital Expenditures

Three years FCF of ARBL is taken out by-

Description	2011 -12	2012 -13	2013 -14
Cash from business activity (after income tax)	296.28 crore	Rs.335.46	Rs.278.7
capital expenditure	Rs.86.58	Rs.72.47	Rs.330.3
Free cash flow (FCF)	Rs.209.7	Rs.262.99	(Rs.51.6)

Take a look at ARBL’s Annual Report for FY14 and calculate Free Cash Flow:

Note that while computing Net Cash of Operating Activities, Income Tax has been deducted from it. The score for operating activities net cash is highlighted in green and capital expenditure is highlighted in red.

Here a question may arise in your mind that when we are working out the future free cash flow why do we need to calculate this historical free cash flow? The answer is very simple we have to predict the future free cash flow in the DCF model. To do this we have to see by what average the free cash flow has been growing historically so far and based on that we can predict the future free cash flow.

Now the question is at what rate to predict the growth of free cash flow. Can it grow at a constant rate? It should always be kept in mind that the rate of its growth should not be kept very high. Personally, I always want FCF to be taken out for at least 10 years. To do this I predict a fixed rate for the first 5 years and for the subsequent 5 years the rate is lower than before. To understand this properly, look at the example below:

Estimate Average Free Cash Flow

First let’s take an average of last 3 years of ARBL –

(209.7+ 262.99 + 51.6)/3

= 140.36

The advantage of taking the average of the free cash flow for the last 3 years is that we get an idea of ​​each type of situation and also the impact of the ups and downs in the business. For example ARBL’s latest cash flow is 516 crores which is negative. Obviously, this will not give an accurate picture of ARBL’s cash flow. That is why it is necessary to take the average free cash flow only.

 Identify the pace of growth

Take any rate for growth that you think is reasonable and reasonable and that you think the average cash flow can grow at the same rate. I usually divide cash flow speed into two parts. I keep the first part for 5 years, then keep the next 5 years in the second part. In the case of ARBL, I anticipate a growth rate of 18% for the first 5 years and a growth rate of 10% for the subsequent 5 years. If a company has a good business and has become a big company, I would probably have a 15% and 10% pace. The less you expect in your estimate, the better.

Estimate Future Cash Flows

We know that the average cash flow for 2013-14 was 140.36 crores. Now with a growth rate of 18%, the estimate of the cash flow rate for 2014-15 would be:

= 140.36 *(1+18%)

= 165.62 crore

Free cash flow for the year 2015-16 will be:

= 165.62*(1+18%)

= 195.43 crore

Similarly you can also do further calculations.

Estimating Future Cash Flow –

No.	Year	the estimated rate of growth	Future Cash Flow (Rs. Crores)
01	2014 – 15	18%	165.62
02	2015 – 16	18%	195.43
03	2016 – 17	18%	230.61
04	2017 – 18	18%	272.12
05	2018 – 19	18%	321.10
06	2019 – 20	10%	353.21
07	2020 – 21	10%	388.53
08	2021 – 22	10%	427.38
09	2022 – 23	10%	470.11
10	2023 – 24	10%	517.12

You give us a pretty good estimate of the future price free cash flow. But you may ask how accurate this estimate is. After all, while estimating free cash flow, we are also taking into account the company’s sales, expenses, business cycle and so on. That is why this estimate of free cash flow is also an estimate only. That is why it is important that you at least estimate as carefully as you can while estimating free cash flow. We have estimated 18% and 10% here which is very low for a good and growing company.

The Terminal Value

We have tried to estimate the future free cash flow for the next 10 years. But what will happen to the company after 10 years? Will this company continue or not? A company is considered to be a commodity that continues to operate. This also means that as long as the company continues to run, there will be some free cash coming in. But as the company gets bigger, the speed of free cash slows down.

Terminal growth rate is the rate at which a company’s free cash flow grows after 10 years. The terminal growth rate is generally considered to be less than 5%. Personally, I consider the terminal growth rate to be in the range of 3% to 4%. Terminal value is the sum total of all future cash flows after 10 years. To calculate this, we need to multiply the 10th year cash flows at the rate of terminal growth rate. The formula to extract it is slightly different:

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

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

Remember that the FCF here is of 10th year. Now take the terminal value of ARBL at a discount rate of 9% and a terminal growth rate of 3.5%:

= 517.12*(1+3.5%)/(9%-3.5%)

= Rs 9731.25 crore

Net Present Value (NPV)

Now we also know the future free cash flow of 10 years and we also know the terminal value (which is the free cash flow of ARBL from 10 years onwards till infinity). You have to find us the value of this free cash flow in today’s price. You will remember that we call this the present value. If we take out the present value, then we can also calculate the net present value.

For this we assume a discount rate of 9%.

For example, in 2015-16, ARBL is to receive 195.29 at a discount rate of 9%. Its present value will be:

= 195.29/(1+9%)^2

= 164.37 crores

The present value of future cash flows will be as follows:

No.	Year	Growth rate	Future cash flow (Rs. Crores)	Present Value (Rs. Crores)
1	2014 – 15	18%	165.62	151.94
2	2015 – 16	18%	195.29	164.37
3	2016 – 17	18%	230.45	177.94
4	2017 – 18	18%	271.93	192.72
5	2018 – 19	18%	320.88	208.63
6	2019 – 20	10%	352.96	210.54
7	2020 – 21	10%	388.26	212.48
8	2021 – 22	10%	427.09	214.43
9	2022 – 23	10%	470.11	216.55
10	2023 – 24	10%	517.12	218.54
Net present value of future cash flow (NPV)				Rs.1968.14 Cr.

Along with this we have to work out the net present value for the terminal value as well. For this we need to discount the terminal value from the discount rate.

=9731.25/(1+9%)^10

= Rs 4110.69 crore

Thus the total present value of the cash flows would be:

= 1968.14+ 4110.69

= Rs 6078.83 crore

That means from here today we can see that ARBL is going to generate a lot of free cash flow in future. That is, the shareholders of ARBL will get Rs 6078.83 crore.

Share Price

Now that we have reached the end of the DCF analysis, we will now calculate the share price based on the future free cash flow of ARBL.

We know how much free cash flow ARBL is going to generate, we also know the total number of outstanding shares of ARBL, dividing the total free cash flow by the total number of shares gives ARBL’s per share price.

But before doing this, we also have to know the net debt of the company i.e. total debt. We will get this figure from the balance sheet of the company. To get this, the total debt of this year has to be subtracted from this year’s cash and cash equivalent.

Net Debt = Total Debt for this year – Cash and Cash Balance

Net Debt = Current Year Total Debt – Cash & Cash Balance

Net Debt of ARBL (As per Balance Sheet of FY14) –

Net Debt = 75.94-294.5

= (Rs 218.6 crore)

This figure being negative means that the company has more cash (cash) than debt. Now it has to be added to the total present value of the cash flow.

= 6078.83 – (218.6)

= Rs 6297.43 crore

Dividing this number by the total number of shares will give us the company’s share price. It is also called intrinsic value of the company.

Share Price = Total Present Value of Free Cash Flow / Total Number of Shares

Share Price = Total Present Value of Free Cash flow / Total Number of shares

As per the annual report of ARBL, the total number of shares of the company is 17.081 crores. Therefore the intrinsic value of the company is:

6297.43/ 17.08

= Rs 368 per share

In this manner, the DCF model is used.

Modeling Error and Intrinsic Value Band

The DCF model is made scientifically but it works on the basis of many assumptions. So there is always a possibility of some mistakes in it. Therefore, it should be assumed that we may have made some mistakes in our estimates and only after correcting those mistakes should we look at the intrinsic value. Intrinsic price can be viewed as a band to reduce the impact of mistakes. Personally, I would expect the intrinsic value of the stock to go up 10% and down 10%.

Look at your calculation above and add this formula:

Lower band of Intrinsic price = 368*(1-10%) = Rs.331

Upper band of Intrinsic price = Rs 405

So instead of assuming the intrinsic value of the stock as Rs 368, I would assume that the price should be between 331 and 405.

Keeping this band of price in mind, we look at the market price of the stock. From which we know that:

If the share price is below the intrinsic price band, it means that the stock is undervalued or undervalued. So the stock should be bought.
If the share price is between the upper band and the lower band then it means that the share price is correct and no fresh purchase is required at this price. You can hold the share if you want.
If the market price of the stock is above the upper band of the intrinsic price, it means that the stock is getting expensive. In such a situation, the investor should either book profit or stay in the stock. In this case, you should not buy at all.

Keeping these things in mind, let us once have a look at the price of Amara Raja Batteries Ltd. This price has been shown on the NSE website as on 2nd December 2014.

We can see that the stock is selling at ₹726.70 which is well above the band’s intrinsic price band. Clearly, buying the stock at this price would mean buying it at a much higher valuation.

Identification of Buying Opportunities

Long term investing is like a slow vehicle whereas active trading is like a very fast bullet train. That is why when a long-term investment opportunity comes, that opportunity remains in the market for some time, it does not suddenly disappear. For example, we know here that the stock of Amara Raja Batteries Ltd. is overvalued i.e. selling at an expensive price. A year ago, the same stock was available at a different price. Look at this chart and remember that the intrinsic price band for ARBL share is in a range of ₹331 to ₹405.

In the portion highlighted in blue, you can see that the stock remained in its internal price band for 5 months. If you had bought this stock at that time, then you just had to forget about the stock and now you would be sitting on a decent return.

Perhaps that is why it is said that in a bear market or in a bearish market, many things are available at a good price. You must remember that the market was in a downturn in 2013.

Conclusion

In the last 3 chapters, we have looked at different dimensions of equity research. You must have understood that equity research means looking at a company in three distinct phases.

In the first step we look at the quality of the company. In this, we look at the company with questions like when, why, and how. According to me it is very important at this stage of equity research if you are not satisfied with the quality of the company then don’t go ahead. Remember that there is no dearth of opportunities in the market, so there is no need to force any opportunity.

After being completely satisfied with the results of the first stage, then move on to the second stage where the performance of the company has to be seen. For this I have made a check list and shown it to you. That’s my checklist and I think it’s a good checklist. But I expect you to make your own checklist and base it on your arguments.

After the second stage comes the third stage in the final part of equity research in which we look at the intrinsic value or intrinsic value of the company and compare it with the market price of the stock. If the market price of the stock is less than the intrinsic value, then it is clear that this is a good time to buy the stock. If all the three steps satisfy you, it means that you are fully aware of the stock and you have made up your mind. Once you buy a stock, stick to it and don’t be bothered by the day-to-day volatility.

I have created an excel sheet of DCF model of ARBL which you can download from here and based on this you can calculate for other companies also.

Highlights of this chapter

• To calculate the free cash flow of the company, we have to deduct the capital expenditure or capital expenditure from the cash received from the business activities.
• Free cash flow tells us how much money is left over for the company’s investors.
• Based on the current year’s free cash flow, the free cash flow forecast for the coming years is made.
• In your prediction, it is better to keep the estimate of the rate of growth of free cash flow low.
• Terminal growth rate is the rate at which a company’s cash flows grow after the terminal year.
• Terminal value is the value at which a company’s cash flow increases to infinity from the terminal year onwards.
• Both future free cash flow and terminal value have to be discounted to today’s price.
• The sum total of all discounted cash flows (including terminal value) is called the total net present value of cash flows.
• After subtracting the total debt from the total net present value of cash flows, if we divide it by the total number of shares, we will get the intrinsic value of each share of the company.
• After working out the internal share price, we should take into account the modeling error in it, for this we can create a band of 10%
• This 10% band is called the intrinsic value band.
• A stock found below this band is considered a good buy whereas a stock above this band is considered expensive.
• Buying an undervalued stock at a low price increases your wealth
• This means that the DCF analysis tells the investors whether the stock is a good buy at the current price or not.