Excercise SheetXXX: 2-Stage DCF

Figures in Rs Billion | Enter values only in red cells

Initial Cash Flow
Vishal: Safal Niveshak: Normalize!

It's better to take a 3-5 years average FCF as this starting number instead of the latest year's FCF. This is for the simple reason that the latest year can be a best/worst number.

FCF can be calculated from the Cash Flow Statement in the annual report.

FCF formula = Net Cash from/(used in) Operating Activities minus Purchase of Fixed Assets1.994(Average of last 3 years FCF)

Years
Vishal: Safal Niveshak: In a 2-stage DCF, we break the next 10 years into two phases of five years each, and then calculate the FCF growth based on growth rates assumed in Cells B9 and B10 below.256-10FCF Growth Rate
Vishal: Safal Niveshak: Be conservative!

Prefer to value stocks based on the present data rather than what will happen in the future. Anything could happen even in 1 year, and if the growth rate is too high and the company cannot meet those expectations, there is no where to go but down.

The best practice is to keep growth rates as low as possible. If the company looks to be undervalued with 0% growth rate, you have more upside than downside. The higher you set the growth rate, the higher you set up the downside potential. Just be reasonable and use common sense.

On most of the stocks I value, I rarely go above 20% (for the first 5-year period), and thats only for the safest, cash-generating businesses.

The goal of choosing a growth rate is to find a number which is conservative yet not very low or pessimistic, and close to reality in order to capture potential future gains without eliminating too many investment candidates.20.0%20.0%Why DCF? The value of a business is simply the present value of cash that investors can take out of the business over its lifetime.Discount Rate
Vishal: Safal Niveshak: This is the rate at which you discount the future cash flows to the present value.

So what would be a good rate? Considering that the average market return is about 10-15%, a minimum discount rate should be set to 10%. I use 10% as a minimum for stable and predictable companies such as Colgate, Infosys, HUL while 15% is a good return for less predictable companies such as, say Opto Circuits.

Also, do not adjust the entire risk of a investment in its discount rate. In other words, if Opto Circuits is a "riskier" investment that say Titan, adjust for some risk in the cash flow growth estimates and some in the discount rate.

Ignore simple yet junk models like CAPM to get the discount rate. People in the finance world pour out their hearts to obtain the most accurate discount rate by analyzing risk free rates, beta, risk premium and WACC. It's just short of rubbish!

Whats the point in learning every method of hammering a nail when all you have to do is hit it on the head. So do not over-complicate this aspect.

The beauty of old school Graham and Buffett is that their investments are based on common sense, not volatility and other mumbo jumbo.

There is no hard and fast rule for choosing a discount rate. Using a high discount rate to discount the future cash just means you are willing to pay less today for the future cash and vice versa.

Do understand that - You cant compensate for risk by using a high discount rate.

The important aspect is not deciding upon a discount rate, but in being logical and reasonable about cash projections.

Another way you can look at discount rate is to not using different discount rates for different businesses. It won't really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.10%Terminal Growth Rate
Vishal: Safal Niveshak: Since it isnt practical to forecast cash flows for an infinite number of years, its usual to end the DCF with a terminal value.

The best terminal growth rate is 0%, and the highest you should go (for safest businesses) is 2%.1%

Shares Outstanding (billion)0.33088Net Debt Level
Safal Niveshak: Safal Niveshak: This figure is arrived using this formula -

Latest year's Total Debt minus Latest year's Total Cash & Current Investments.

If this figure is negative, i.e., in brackets, it means that the company has more Cash than Debt. This is automatically added to the PV of cash flows below to give a complete picture of the company's valuation.1.5073.16

Present Value CalculationsFinal CalculationsYearFCFGrowthPresent ValueTerminal Year121220%2PV of Year 1-10 Cash Flows332320%2Terminal Value533320%3Total PV of Cash Flows874420%3Number of Shares05520%3DCF Value / Share (Rs)2576620%37720%48920%491020%4101220%5

Initial Cash FlowShares Outstanding (billion)Net Debt LevelDCFFCF Growth Rate

Colgate2.980.2720.65095930%CRISIL2.030.0710.3511878.952232235426%Dabur7.651.7562.10628826%HUL29.642.16312.04078524%ITC51.528.01620.95431922%Nestle12.080.09616.268610222%Voltas1.990.3311.50725720%