As promised last week, I now bring you Valuation 102, the second part of the basic course in my series on valuation. Today we look exclusively at intrinsic valuation. As discussed in Valuation 101 last week, intrinsic valuation is the process of valuing a company based on its inherent characteristics. For those of you reading this piece directly, I recommend you first read last week’s piece, Valuation 101, to better get you up to speed.Today we discuss the why, what and how of intrinsic valuation. More specifically, why intrinsic valuation, what goes into an intrinsic valuation, and how to best carry out an intrinsic valuation. So let’s start by answering the first question, why intrinsic valuation?
We live today in a day and age where everything imaginable is heavily marketed and everything is judged by its cover, not just books. Heck, even people are judged by their outer looks and packaging. The same goes for companies and it applies even more so to companies, because of all the potential for window dressing affairs and business prospects. But we always forget that the true worth of anything is always on the inside and not the outside. Intrinsically valuing a company helps us see past the potential facade and see a company for what its really worth, because a company can only be as intrinsically good as it’s inherent characteristics. So, that’s the why taken care of. Now lets see what really goes into an intrinsic valuation.
Like I already said earlier, an intrinsic valuation is based on a set of any given company’s inherent characteristics, and in addition to that, it is also possible to intrinsically value an entire company, or just the equity in the company . I’ve taken a few of the most important characteristics that go into an intrinsic valuation and explained them below:
- Free Cash Flows: As explained in Valuation 101, free cash flows represent how much residual cash the owners can take out of a business after all necessary payments have been made. But free cash flows can further be divided into two categories:
Free Cash Flows To Firm (FCFF) : Free cash flows to firm represents the amount of residual liquid cash that a company can generate for its owners. This is the ideal starting point if you want to intrinsically value the company as a whole. It can be represented using the formula FCFF = Net Operating Cash Flows + Post Tax Interest Expenses - Net Capital Expenditure. The net capital expenditure is also sometimes termed as purchase of fixed assets. All the required figures are available in the financial statements of the company which can be found in the annual report. (You can always visit the BSE India website for the annual reports).
Free Cash Flows To Equity (FCFE): Free cash flows to equity represents the amount of residual liquid cash that a business can generate for its equity shareholders. This is the ideal starting point if you want to intrinsically value just the equity in the company. It can be represented using the formula FCFE = FCFF - Post Tax Interest Expenses + Net Borrowings. All required figures are once again available in the financial statements of the company.
- Discount Rates: Going back to Valuation 101, discount rates represent risk in the cash flows of the company, which can be used to discount the cash flows to their present values. There are again two types of discount rates as explained below:
Cost Of Equity: Represents the return that equity shareholders expect the company to generate for them in the form of dividends. For example if a company pays a dividend of 5%, then the cost of equity is 5% because that is the amount of return expected by the equity shareholders. FCFE must always be discounted at the cost of equity.
Cost Of Capital: Represents the returns that various providers of capital expect from the company on the proportion of capital provided by them. For example if a company is 70% financed by equity for the expectation of a 5% dividend, and 30% financed by debt for 6% interest, the cost of capital would be 5.3%. For the purpose of calculation, all percentages are converted to decimals (0.70.05) + (0.30.06) = 0.053*100 = 5.3%. FCFF must always be discounted at the cost of capital
- Growth Rates: Growth rates represent the rate at which we expect the company and its cash flows to grow in the future and can be used to predict cash flows in future periods. I won’t delve much into growth here, because Valuation 103 will focus exclusively on growth.
Terminal Cash Flows: These represent the cash flows in the the last year of your investment period. If you have a 10 year time horizon, the terminal cash flows would be the cash flows in the tenth year. So, that shows us what goes into an intrinsic valuation.
Now comes the most important part, how best to carry out an intrinsic valuation. The most widely used technique for an intrinsic valuation is the Discounted Cash Flow Valuation technique. Do keep in mind that a discounted cash flow valuation may not give you the accurate intrinsic value, but it does provide you with the best possible estimate. The steps to carry out a discounted cash flow valuation are explained below:
Arrive at the appropriate cash flows for the length of your investment period depending on what you want to value. If you’re valuing the firm arrive at the FCFF, and arrive at the FCFE if you’re valuing the equity. The cash flow calculations have to be done individually for each year. The simplest way to calculate free cash flows for future periods would be to assume that free cash flows remain constant over time.
Calculate a terminal value for the company you are valuing. There are two approaches to do this.
Approach 1: Terminal Value = Book value per share x Number of shares outstanding. When using this approach we assume that the company will be going into liquidation at the end of our investment period.
Terminal Value = [FCFFn (1+g)]/(r-g)
FCFFn - Free Cash Flow To The Firm for the nth year basically the last year of our investment period
r - Discount Rate converted into decimals
g - Free Cash Flow Growth Rate converted into decimals
When using this approach we assume that the company will still continue to operate and generate cash flows at the end of our investment period.
Discount the estimated cash flows and the terminal value to their present values at the appropriate discount rates (Cost Of Capital for FCFF and Cost Of Equity for FCFE). Never discount cash flows at the wrong discount rates.
Add up the discounted cash flows and discounted terminal value to arrive at the Net Present Value or NPV.
Compare the NPV to the current market cap of the company you are valuing
If market cap < NPV, the stock is undervalued and if market cap > NPV the stock is overvalued
And that is how you carry out a discounted cash flow valuation to find the intrinsic value of a company.
As this extremely long piece comes to an end, I would like to remind that while doing an intrinsic valuation exercise may seem like a mountain to climb at first, once you’ve done it a few times it will be child’s play to you, and will give you an absolutely massive edge over other investors. See you next week for Valuation 103, where we will see how growth affects the value of a business