Discounted Cash Flow

There’s no doubt that value investing is all about the growth and risk in cash flows. DCF is what future money is worth now.

DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to both financial investments for investors and for business owners looking to make changes to their businesses, such as purchasing new equipment.

Mathematically,

You divide your Rupee figure, let’s say 5 rupees by 1+the interest rate to the power of no. of years you want to discount.

Assume the interest rate/WAAC/ Discount rate to be 7% and the no. of years to be 10, then

Discount to Today = 5/(1+7%)¹⁰

So, the generalized formula is

‘x’ Rupees in future/(1+i%)^time

There are some terms that you have to be familiar with to understand the whole working of a DCF model :

Free Cash Flow: It tells you the real amount of cash that is left in your pocket. The formula goes like :

FCF = Operating Activities- Capital Expenditure (Property, plant or Equipment).

Capital expenditure is widely known as ‘Capex’.

Basically, FCF is Operating Activities-Investing Activities from the given cash flow model

Calculating the Weighted Average Cost of Capital (W.A.C.C)

This is also known as the interest rate or discount rate.

WACC = The cost of the company to use the debt ‘x’ the percentage of capital that is actually debt + the cost of the company to use equity ‘x’ the percentage of capital that is equity

So, the cost of debt= Cost to use debt /Interest on a bank loan x (1-tax rate)x % of the capital that is actually debt

Here, we have assumed that govt. must have given tax incentives on taking a loan. Let the interest rate = 5% ,% of capital i.e. debt = 20% and tax rate be 30%

So, the cost of debt = 5% x (.70) x 20% = 0.7%

Now, we have to calculate the Cost of Equity

The cost to use equity is a bit complex as compared to debt calculation. We calculate the cost of equity relative to the stock market as the whole market can have a huge impact on a single stock and vice-versa.

So, the formula goes like :

Cost to use Equity = Percentage of capital i.e. actually equity x risk-free rate+(how volatile the stock is) x (what the stock market will do- risk-free rate).

Here Risk-free rate is referred to the govt.’s interest rate or the safest interest rate. Volatility or risk of a stock is measured by Beta. Beta of stock market is usually 1.

Let the % of capital i.e. actually equity be 80%, risk-free rate = 2.5%, Beta of that stock = 2, and the stock market return be = 8.5%

So the cost of equitty= 80% x 2.5% +(2) x (8.5%–2.5%) = 11.6%

So, WACC = 0.7% + 11.6% = 12.3%

Calculation of Terminal Value :

Previously, we were taking future rupees value 10 or 15 years from now on. But we can’t ignore the fact that there are companies which have been operating for a period of more than 50 years as well. So, we calculate a terminal value for infinity no. of years. We then discount that value to the present.

Terminal Value Formula = Final year FCF x (1+long term growth rate)/(Interest rate-Long term growth rate)

As per the previous record, the Interest rate is found to be always more than the long term growth rate which is generally 1 or 2%.

Suppose Final year FCF = 1100.4

Growth rate = 2%

Interest rate = 7%

So, Terminal Value = 1100.4 x (1+2%)/(7%-2%) = 22,652

Then we discount it to today,

= 22,652/(1+7%)¹⁰

= 11,515.12

The above steps are necessary to track the working of Discounted Cash Flow.