Recently I have been trying to get my head around using DCF analysis as a method to value a stock. Being an engineering student with no experience in finance, some of the concepts here have always been hard to come by. One particular area which continues to baffle me is the discount rate or weighted average cost of capital to use when calculating the present value of future cash flows.
What are the factors that are likely to affect the cost of equity component? I understand cost of equity as a measure of opportunity cost of investing in the stock as opposed to one with a similar risk profile. Pat dorsey in his book uses a base value and then compares stocks and assigns a value as compared to that base value.
Is there a base value that we can use for Indian equities? Can we assume that the indices on BSE and NSE have grown at the rate of approx. 16-18% over the last 30 odd years and are likely to grow at a similar rate for the next 10 years. So would it be prudent to compare the stock that you are analysing against this value of lets say 18% and compare its risk premium/discount as compared to an average stock? So if a stock has higher promoter pledging or not so strong of a competitive moat you would want to discount it at say 18+4%? If so, what would be the “average” COE for an “average” SENSEX stock, and similarly an “average” midcap or a smallcap index stock?
Lets say now that you are fully invested and trying to decide between retaining a particular stock in your portfolio or switching to a new one. Will this have any impact in the Discount rate when calculating the value of the new stock that you are evaluating?
Would love to have comments from some senior investors!