Assumptions
Lupin will continue to grow at 3% after 3rd year
Discount rate continue to be at 10%
Terminal Value = [FCFFn (1+g)]/(r-g)] =(2962.097*(1+0.03))/(0.1-0.03) = 43585.14 crore.
In the above how did you arrive at the fcff of 2962. Can you please explain.
2962 is the FCFF at the end of 3rd year. Following is the explanation.
Assumptions
Cash flow increment 5% for 3 years
Discount rate 10%
Perpetual growth = 3%
Facts as on 31-Mar-2017 (in Cr)
Net cash flow from operations 4115
Interest expenses 152.53
Tax rate % 30.00
Net capital expenditure 1663.00
Post tax interest expense 106.77
FCFF at 0th year 2558.77
Future cash flow for next 3 years at 5% growth
Year 0: 2558.77
Year 1: 2686.71
Year 2: 2821.045
Year 3: 2962.097
Hope this helps.
Thank you. Now it is clear to me.
Sir , Thanks for your inputs , with the above quote can you please , for the sake of better understanding , give me an explanation with example of Graphite India of what could be the CoC ?
@pramodguru Thank you so much for your valuable feedback.
Conceptually, cost of capital is nothing but the minimum amount of returns that the various parties who provide capital to the company, such as equity shareholders, preference shareholders and lending banks, expect from the company, in return for the funds provided by them.
In pure financial parlance, the cost of capital is also called the Weighted Average Cost Of Capital (WACC). It is arrived at by multiplying the proportional weight of each component of capital in the total capital structure by the cost of each individual component.
In my example I had assumed a rate of 10% as the cost of capital for ease of calculation, but it is also possible to calculate the exact cost of capital rates.
This will be made clear by the following example.
Let us assume that Graphite India Limited has 70 crore of equity capital, in return for which shareholders expect an annual dividend of 7%, and 30 crore of debt, in return for which the bank expects 6% interest per annum.
This reveals that Graphite India has a total capital of 100 crore, in the ratio of 70% equity and 30% debt. The equity costs 7% because that is the dividend return expected by shareholders, and the debt costs 6%, because that is the amount of interest expected by the bank.
Now to come up with an overall weighted average cost of capital we follow the following calculation.
Weighted average cost = Ratio x Cost of individual component
Weighted average cost of equity = 70% x 7% = 4.9%
Weighted average cost of debt = 30% x 6% = 1.8%
Therefore, WACC = 4.9% + 1.8% = 6.7%
Hope you find this explanation helpful.
Thanks Sir
2 More queries here :
If you can attached some links as study material it will be helpful , as my my questions might look very basic for you .
Thanks in advance , Pramod
@pramodguru First off, there are no basic questions and it is my pleasure to answer your questions. I am a newbie in the financial markets (less than six months old in the markets), and I am not well versed in valuation by any means. I too am just learning the ropes of all these aspects
Coming to your first question, we always consider only long term debt because capital is always made of long term sources of funds.
The cost of equity can be calculated using the following formula:
Cost of equity = D1/(k - g)
Where,
D1 = Expected dividend next year
k = rate of return expected by the investor
g = Expected dividend growth rate
The cost of debt is just the nominal interest rate offered by the bank.
Coming to your second query, as you rightly said, the interest cost of debt is always tax deductible, and hence increasing the proportion of debt in the capital structure brings down the overall cost of capital.
Hope you find these explanations useful.
Hi,
The discussion on here is very thought provoking and formative for the newbies like me. Thank you one and all for imparting such invaluable knowledge to the ones scouting for it.
Without straying from the Pharma theme, I would like to put forth my calculation for Syngene International (I had been allotted Syngene shares in the IPO) for your consideration. I would like you to check to see if the data I have pulled from two different sites is correct or not. (I have pulled the data as on March 31, 2017 from screener and 4-trades sites) as Iām getting results that seem to be amiss. Itās either me doing something awfully wrong or the valuations are stretched beyond (my) belief. Please have a look
Net Operating Cash Flows + Post Tax Interest Expenses - Net Capital Expenditure
397.70 + 14.35 - 293.1 = 118.95
FCFF = 118.95
Assuming
CF Gr = 3%
Discount = 10%
DCF Calculation
Year 0 118.95
1 118.95 + 3% = 122.5185 * 0.909 = 111.369
2 122.5185 + 3% = 126,194 * 0.82644 = 104.286
3 126.194 + 3% = 129.979 * 0 .7513 = 97.653
NPV = 432.258 + Terminal value = [FCFFn (1+g)]/(r-g) = 26.054 (1+,02)/(.909-,02)
432.258 + 129.979 (1+.03)/(.1-.03) = 2344.79 Cr ?
So according to the calculation vide supra, the market cap at the end of year 03 should be 2344.79 Cr. while the current market cap is 11,800 Cr.
Iām sure I have made some laughable mistake on account of being unaccustomed to such procedure. Would appreciate if it is brought to my notice.
Also I have taken the Tax rate = 18% (As thatās the highest tax they appear to have paid thus far. I have taken the growth rate at a meagre 3 % I donāt know if thatās acceptable.
I would be grateful if someone helps me understand this.
Thank you ā¦
The original post mentions that FCFE and FCFF should only be discounted at the Cost of Equity and the Cost of Capital respectively. Thatās probably true from a Corporate Finance perspective. However, from a valuation perspective, shouldnāt the cash flows be discounted at the Required Rate (An arbitrary rate decided based on the investorās expectation of the returns he wishes to earn by investing in the stock)?
That is to say, the Required Rate can be lower or higher than the Cost of Equity/Capital and it varies from investor to investor.
Food for thought.
@walkie.talkie [quote=āwalkie.talkie, post:51, topic:14795ā]
Terminal value = [FCFFn (1+g)]/(r-g) = 26.054 (1+,02)/(.909-,02)
[/quote
Can you please explain your calculations in this quoted section because the calculations in the quoted section seem wrong, but when you have carried out the actual calculations of the terminal value just after the quoted section, you have done it absolutely right.
All your other calculations seem okay. So, based on your calculations, Syngene is highly overvalued on an intrinsic basis.
@dineshssairam The Cost Of Capital and the Cost Of Equity are the default rates assumed to discount cash flows. But you are absolutely right, in practice, discount rates can be arbitrary and can vary from investor to investor.
But it also important to keep a few things in mind when assuming an arbitrary discount rate.
First, if youāre assuming a discount rate that is lower than the cost of capital, you would be losing out on that much return.
Understand that corporate finance is a two sided coin. What is cost for the company is return for an investor. So if the company incurs a cost of capital of 10%, the investor can in turn expect a return on capital of 10%.
Now, lets assume that you expect a return of 7%. But the company incurs a cost of 10%, and therefore also generates a return of 10%. So you are effectively losing returns worth 3% (10% - 7%). The only situation where it makes sense to assume a lower rate of return is where the company is in decline or close to liquidation, because in such a situation, the ability of the company to generate the required returns would be suspect.
Secondly, if you want to assume a rate of return that is higher than the cost of capital, you must have reasonable confidence in the ability of the company to keep generating excess returns over the entire length of your investment period.
So suppose you assume a 15% discount rate with a 10 year investment period, but the company currently generates only a return of 10%, you must be fairly confident that, going forward, the company will be able to generate returns of 15% per annum for all 10 years of your investment period.
Discounting at cost of capital is done, because the cost of capital invariably represents a risk free rate of return for an investor.
Hope you find this explanation helpful.
HI,
@ Akshay_Nayak
Terminal value = [FCFFn (1+g)]/(r-g) = 26.054 (1+,02)/(.909-,02) <----- Even I can't figure where that bit came from. Must be the leftover calculation part from my earlier attempts to evaluate an entirely different company. Sorry about that mess.
So NPV = 432.258 + Terminal value = [FCFFn (1+g)]/(r-g)]
432.258 + 129.979 (1+.03)/(.1-.03) = 2344.79 Cr
^^^ I'm glad that this bit seemed okay to you.
And I guess it's safe to assume that with a very conservative approach, the assumptions part ie- Growth rate (@ 3%) and Discount rate (@ 10%) wouldn't appear haywire either.
Thank you for responding :-)True. Thank you for your answer. While Cost of Debt is fine, Cost of Equity emerges from price movements, which is completely controlled by the market. If a good investor does not follow the crowd, why should he consider the Cost of Equity dictated by the market, which may be wrong, just as the price dictated by the market may be wrong?
In fact, only if the market is wrong about the price can an investor make superior returns. This is the single most important query Iāve always had about using a Beta in my valuation models. I still do, but I am very skeptical.
If you could answer this, I would be grateful.
@dineshssairam Yes I understand your contention. Regular cost of equity models are all based on market price. And when using the CAPM model which takes market price out of the equation, there is the issue of betas to contend with.
What we must first understand about the beta of an asset is that it is a measure of the relative risk of the asset. Now, just because beta is complicated doesnāt mean we entirely ignore the relative risk.
When it comes to stocks, if using betas is complicated, I suggest the use of earnings and earnings growth as a measure of relative risk. So, look at the earnings of a stock over a considerable amount of time in the past, say 5-10 years, and see how stable the earnings are and how well they are growing.
So a company which has predominantly stable earnings and is able to grow earnings steadily over a period of time, can be seen as low risk companies compared to those which canāt. So overall the cost of equity would be the risk free rate + the average earnings growth rate. The risk free rate is usually assumed to be the prevailing rate of return on government bonds, because that is minimum amount of returns that all asset classes can be expected to generate.
Now, a couple of points to be borne in mind when using earnings as a measure of relative risk. First, almost all bits of earnings data are mostly accounting numbers. When such is the case, there is always the risk of deliberate misstatement and fraud, although such instances are not recurring in nature.
Secondly, it is also important to keep in mind that the earnings picture can be distorted in the cases of cyclical and commodity companies, whose earnings get distorted by business and commodity cycles respectively.
A good tip would be to look at the average earnings of such companies, during the normal phase of the respective cycles, while ignoring the earnings during the boom and bust phases of the cycle, because they would distort the averages. Cyclical and commodity commodity companies with stable and steadily growing earnings during the normal phase of the respective cycles can be considered less risky compared to other cyclical and commodity companies.
Hope you find this explanation helpful.
Thank you again. I personally prefer Bottom-up Betas (Even though they are, to some extent, still dictated by the market). Prof. Aswath Damodaran explains about it here wonderfully:
Learn discounted cash flow after reading this article.
Can we substitute Net Profit for cash flow from operating activities as the operating cash flow for most companies highly varies between years while net profit is a gradual increase.
For the same reason, can we use average cash flow from investing activities for letās say the last 4 years as the investment highly varied between years and even a positive amount in some years?
The cost of capital is an opportunity cost. It is the return that you choose to forego from your next best investment alternative. For stock pickers whose goal is to beat the index - the cost of capital is the long term return provided by the market index because that is what we are trying to beat by investing in individual companies.
@SlownSteady With respect to your query regarding the use of net profits or investing cash flows instead of operating cash flows, let us first understand what operating cash flows are.
Operating cash flows are cash flows generated by a company as a result of its day to day operations. Free Cash Flow is designed to find out how much the owners of a company can take home by way of liquid cash as a result of its core business activities. And the core business activities are nothing but the day to day operations.
Net profits and investing cash flows are both one time cash flows. Net profits are cash flows only generated once at the end of every year and investing cash flows are generated only on purchases or sales of fixed assets which are not recurring activities.
It is therefore better to use operating cash flows when calculating free cash flows because operating cash flows are recurring in nature and more sustainable.
If a company has inconsistent operating cash flows, it is better to stay away from such companies, because the best companies consistently generate positive operating cash flows and positive free cash flows.
Hope you find this explanation helpful.