Numbers and Narratives: A Simple Discounted Cash Flow (DCF) Model for Equity Valuation

Thanks for the clarification. So for companies that don’t issue debentures in the market, can we take the post tax cost of debt from the income statement?

The order of importance I give is:

  1. Yield on Own Debt
  2. Yield on Comparable Competitor’s Debt
  3. Book Cost of Debt

So if #1 and #2 are not available, then sure.

1 Like

@dineshssairam I have another question related to finding the Cost of Equity from a basic CAPM based model.
I was looking at several definitions (Investopedia for example) and found that CAPM is derived from the Price of the underyling stock price and the overall market returns. Can I plug this Cost of Equity in a WACC calculation model? I am confused here because in WACC - the cost of debt is the Yield on the debt as you have explained above. For the cost of equity, can I use the stock price based CAPM or should I consider Dividend yield?

P.S - Sorry for bombarding so many questions in a single day! I am a newbie and I don’t have a finance background :grinning:

There is a difference between the companies rate of return and your rate of return

A company uses its own rate of return to evaluate project IRR on a new expansion

For arriving at a valuation you would first see if what you can reasonably get from the bank. This is your risk free rate. To that you would add the risk and inflation as even bank rate you get can be beaten for instance by investing in a non inflationary unit of money

You are then discounting the future cash flows with that rate.
Using a company rate sometimes short cuts the process as you assume that banks are generally more efficient and if they are giving one company 9pc and another company 13pc, they feel the second company is more risky so you are using their analysis to cover your risk

Ideally you should have an idea of how banks price it. The higher the debt of a company the riskier it gets. So one company with a higher cash balance and lower debt might have a lesser risk and hence higher valuation than the one with higher debt

This is also the reason a well run company with good cash reserves command a higher valuation as the risk is lower and hence you are discounting future profits with a lower denominator

Do you know if he made and money on stocks or it’s purely theory
I tried searching what his net worth is and didn’t get very far
He should have been very successful by now and probably be running a large fund for the knowledge he shares

Some time back, I calculated the Cost of Capital of Reliance Industries from scratch and posted it in a different thread. Hope this helps you.

2 Likes

Don’t know, don’t care. If learning came with conditions of wealth, we’d miss out on some amazing material from the likes of Michael Mauboussin, Nicholas Nassim Taleb and even Benjamin Graham.

But if you’re tracking that sort of thing, I think he purchased Apple as early as in 1997 and sold it in 2012.

Nassim Talebs fund made 5000+ return in the covid crash although I think he exited a bit earlier out of desperation
Benjamin Graham retired very rich
Black scholes didn’t make anything neither did the efficient theory proposes

If you’re in a game of saving money you need to care. If you are in charity then don’t care

if your going to war, don’t ask a coward how to fight but then again wars are fought by idiots and if you’re smart you’d ask a coward on the best strategy to avoid fighting one
As far as you know what you want

2 Likes

You are a goldmine of information. Thanks for this. You should start uploading finance videos on Youtube! I am going to use the Reliance Industries sheet as my WACC template from now on. Its very simple!

The one thing in Cost of Equity computation that kind of bothers me is that we are using the CAPM model which is based on the underlying stock price, the historical market returns and of course the Risk free rate. I still don’t get why we are using this computed cost of equity in the Cost of Capital Calculation.

From what I understand, the Cost of Capital (or WACC) implies that the company has to generate enough returns for servicing its cost of debt + cost of equity. Here Equity is taken as the Common Stock + Reserves from the Balance sheet. So for the Company, ideally shouldn’t the cost of equity be the dividend that it pays out to shareholders rather than the actual stock price which has nothing to do with the Common Stock + Reserves in the Balance sheet?

However, I do get that as shareholders of the company, we are looking at absolute stock price returns and hence we are using the CAPM model described above.

Please correct me if I am wrong.

Hey Dinesh,

Based on your advice, I started listening to Prof. Damodaran’s lectures. I’m a Mech. Engg by training & have zero finance background.

My experience with his lectures thus far has not been very encouraging. I feel his lectures are way too long & wordy (sleep inducing in my case). Could you suggest something/someone simpler who sort of hand holds & teaches novices with no background? I like Vishal Khandelwal’s (Safal Niveshak) way but lot of his lectures are now paid.

Btw, I also went through your blog & the DCF model that you have created. Beautiful as it looks, I can’t understand much yet :grimacing:

Thanks for your help!
Cheers

1 Like

You’re right. I don’t agree 100% with the CAPM either. Read this post to know more about my opinions on Cost of Capital:

Yes. And the Present Value of all Future Dividends is the Value of the company. Price is the proxy for Value. So, the CAPM uses that.

If you would rather use Dividends to arrive at the Cost of Capital, you can do that by working backwards in the Dividend Discount Model (Refer to the first section here):

Ultimately, don’t break your head over the Cost of Capital figure. Your time is better spent understanding the business and the cashflows than some decimal points in the Cost of Capital.

1 Like

Start with “The Dhandho Investor”. Once you are comfortable with the concept of a Discounted Cashflow, subscribe to https://www.asimplemodel.com/ and try using their models. Once you get the hang of the models, try building one yourself.

My DCF Model is not the golden source. Don’t worry if you don’t understand it right away. You can build a better one if you put in enough work.

I agree that the Professors videos are not for beginners. You require prior understanding of Accounting and Finance to make the experience of learning from him smoother. If you are still interested in watching the Prof’s content, I suggest you start with this series on Undergraduate Valuation:

1 Like

Hi Raghav,

I couldn’t help replying to this as I strongly believe you are going about learning to invest the wrong way. While Dinesh Sairam does an amazing job in DCF calculations, I am not very sure this is very useful in the real world of investing. DCF may be very useful if you plan to work for an organisation that requires this to be done. However, if you want to improve your investing skills, I believe your time will be much better spent in understanding industry structures, businesses and their moats, competitive positioning, potential of a business, skill of management and a thorough reading of the annual reports and conference calls.

DCF relies on too many variables that are difficult to predict with the result that your valuations almost always tend to be incorrect. You could much easily arrive at your assessment of enterprise valuation ranges by using much simpler levers of valuation (earnings power, fair valuation, potential opportunity size, franchise value etc) - If these levers of valuation don’t show value, dcf is unlikely to change this assessment - at best it will reinforce it. From a finance perspective, you should perhaps learn to read and understand an annual report - P&L, Balance Sheet and Cash Flow Statement, be able to determine and understand certain key ratios (operating profit margin, RoCE, RoE, Debt Equity, Inventory Turns, Tax Rates, Operating Cash Flows, Free Cash Flows, Dividend yield amongst others) and the relationship between the two.

I would suggest romancing the balance sheet by Anil Lamba, Value Investing: From Graham to Buffett and Beyond and Benjamin Graham’s Security Analysis towards this end.

Regards
Shivram.

@dineshssairam - apologies in advance for my views as above, I know you consider DCF in high regard. I do respect your skills and opinions (spent 3 days going through DMart thread and the interesting conversation on DCF there) on the same.

1 Like

No issues. I have said this in some places. DCF is a tool, a good one at that.

But if you don’t know how to fix a bike, even the world’s best spanner isn’t going to help you. In the same vein, even if you’re the best bike mechanic in the world, you can’t fix a bike without the right spanner.

It’s not either all those things you mentioned or DCF. It’s both. DCF isn’t some monster that sprung from the netherworld of Corporate Finance. It’s very logical and simply the way money works in our world.

2 Likes

I have no issue with DCF as a tool. It works well for determining bond yields for instance. My only submission is that DCF is not the right tool to fix the “equity“ bike. Equity valuation involves predicting the future and DCF gives a false sense of being able to predict it with precision.

My analogy is as follows. If I were asked to predict how favourably people would predict the weather patterns of the future 5-10 years from now, would I be better off if (assuming of course that I have enough knowledge and experience on understanding weather patterns)
a. I looked at historical patterns, arrived at a mathematical construct, predicted future variables and applied these future variables on the construct to arrive at the possible ranges of expectations on weather patterns 5-10 years from now. Or
b. I understood where the world is with respect to responsible use of resources, what my assessment of on where the world is moving towards and then make a qualitative but well reasoned assessment on whether the weather patterns are likely to be favourable/unfavourable, the extent of the favourableness or unfavourableness and in that frame of mind would people look at future weather patterns favourably or not?

While we may be wrong in both approaches, I believe the second approach should give us much better results.

Did can you used as a roundabout tool

The basic formula is
Future profits / discount rate = ideal current valuation

We know what current valuation is and what the discount rate is. So we can calculate what future profits estimate is built into the current price

Future profits are calculated by applying a growth rate over current profits

So we should be able to get the growth rate built into exiting price

Once we know expected growth rate it’s an easier guessing excercise to determine if the company will achieve Or beat it instead of assuming the growth rate and building the ideal expected market valuation

If someone had you believe that the aim of a DCF is to arrive at an exact Value of a company, then you were most definitely misinformed.

The future holds many possibilities and since Value is 100% in the future, it cannot be a single number. Value is a Probability Curve.

For instance, when I Valued Kajaria Ceramics, this was the end result:

Going with your own example, everything ranging from Weather Predictions to Season Projections to Disaster Warnings run on Probability Models. It’s great to “have a feel” for whether this Monsoon will be heavy or not. But the world does not run on “having a feel”. Why should the world of investment be any different?

Once again, I reiterate that everything you mentioned is important. I don’t disagree. But when you are paying for something, it helps to know what it’s roughly worth.

6 Likes

Leaving the download link to the latest version of the Model. Includes some bug fixes, but a lot of it is still the same.

Is it now better to use reverse DCF ?

Sir can you tell us which valuation metric is suitable for which company. Some companies which trade at 9x book and 6x PEG are only who are trading at 1x sales. ??