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!
@abhishek, i agree with factors affecting and ultimately they are the deciding factor in discount rate but recently i had gone through wealth creation report of motilal oswal and in that the discount rate has been 15% because ultimately for the long run it becomes very difficult to grow more than this kind of rate. ofcourse midcap co.s can grow at 30,40 or maybe 50% but very few made it to the large caps and even difficult to maintain that position. so i think irrespective of the factors 15% discount rate is good for analysing any type of co.
I guess Aswath Damodaran has described well the importance of using appropriate discount rate in one of his articles earlier. Estimating it too high often leaves us with instant gratification business.
One can always use mental shortcuts to arrive at a ball-park number. But sometimes it makes sense to make use of academics and statistics to reduce inherent mental bias which makes it way through discount rate to our valuation modeland affects the final decision.
Disc: I don’t use DCF
Hi Utkarsh and Jatin, lets say we are comparing 2 competing ideas. One is an A+ business and the other one is an A or B category business. Shouldnt the discount rate of the B category business be higher than the A+ simply because consistency of earnings the B category of business is likely to lower? If that is the case wouldnt it be difficult to put a blanket discount rate of 15% on all businesses?
I agree with u Abhishek.
That’s why I think using statistics (if one is bent on DCF analysis) would be a better because it uses industry beta and expected market return. It will, in most cases, give lower value for discount rate for A+ businesses than B businesses.(I’m not advocating using it but m just saying it is much less biased). Using it is not that practical, but one can use it as a base to check if one is over-discounting or under-discounting a given investment.
Applying blanket discount rate of 15% would many times stop us from betting on good business because 15-20% CAGR over a long time in a stable A+ business can give substantial returns with low volatility.
In the end, I believe either a bet is worth making or not, DCF or no DCF. Adding a few basis points to discount rate here and there to rationalize action is never a good option.
While pitting on one A+ business against another B business, I guess, it’s more the feel that decides the allocation rather than calculating odds, returns and applying Kelly’s formula.
P.S> The only time I have used DCF is when I needed to re-engineer to assumptions of growth rate by the market and check if I was comfortable with them.
May I kindly request you to elaborate on
“That’s why I think using statistics (if one is bent on DCF analysis) would be a better because it uses industry beta and expected market return”
I completely agree with you. I use DCF in exactly the same way. Or rather I should say I use reverse DCF rather than DCF to check if I am not making any wild assumptions. But at the end, gut feel or not, the numbers cannot be ignored I feel. Whatever said and done, the value of any stock is as good as the present value of all its future cash flows. Now, it is senseless to calculate that to the last decimal point but I believe that doing a fair calculation with reasonable assumptions should be an important part of the analysis. I might be completely wrong (Im still a newbie!)
On a completely different note, with the markets becoming increasingly more expensive, I am just at a loss as to what to pay and what not to pay for a great A+ steady return low volatility. Most established A+ businesses like Nestle and Pidilite and Asian Paints are quoting at valuations which are far higher than their 5 year or 10 year average range. Now there are plenty of articles which talk about how investors generally almost always underestimate the value of really high quality businesses but I really really want to know that no matter how good a business like Nestle is - how am I supposed to justify the almost 50 times price earnings that it is currently trading at? Perhaps, I was looking to use DCF to do it and the answer probably lies in the fact that using traditional analysis, investors are almost always likely to over discount such high quality?!