Valuation 102: True Beauty Is Always Intrinsic

Investment Learning
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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:

  1. 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).

  2. 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:

  1. 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.

  2. 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.

Approach 2:

Terminal Value = [FCFFn (1+g)]/(r-g)

Where,
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

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shouldn’t cost of equity be divident plus expected roe ?

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Dear Akshay,
Well articulated. Thanks for the initiative.
May be with an example, the article will get its beauty.
I am dumb at accounts and hope your explanation will get added value.
Mai I suggest you to go with an annual report.
Thanks for taking your time out for people like us.
Prasad.

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@12years Yes that is one of the formulae for cost of equity… but what I have covered here in my piece is the basic concept… the formulae and valuation models I will cover in my next piece on growth because then I can show the differences that arise in the value in the presence and absence of growth… Keep following this space

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@Prasad_India First off, thank you so much for your valuable feedback. Your support and appreciation makes all the time and effort I put into these posts worthwhile. Coming to your request for an example, I’m really sorry for not including an example in my post as I felt it would make an already long post even more lengthy. But I will meet your request now.

Consider the following information taken from the annual report of Graphite India Limited for 2017 (all figures in crores):

Net Cash Flow from Operations = 250.16
Interest expenses = 6.5
Tax Rate = 30%
Post tax interest expenses = 4.55 (6.5 - 30%)
Net Capital expenditure = 80.44

Now, FCFF = Net cash flow from operations + Post Tax interest expenses - Net Capital Expenditure

Therefore FCFF = 250.16 + 4.55 - 80.44 = 174.57. This is the value of the FCFF today. Let’s call it Year 0

Now, let us hypothetically assume that Graphite India Limited has a cost of capital capital of 10% and cash flows are expected to grow by 5% every year. Assuming you have a three year investment horizon the free cash flows are calculated as follows:

Year 1: 174.57 + 5% = 183.3
Year 2: 183.3 + 5% = 192.46
Year 3 (Terminal Cash Flow) : 192.46 + 5% = 202.48

Now that we have estimated the FCFF figures, we discount the future FCFFs to their present values at the appropriate discounting rate, which is the cost of capital, which is 10%. Doing this we get:

Year 1: 183.3 x 0.909 = 166.62
Year 2 : 192.46 x 0.826 = 159.09
Year 3 (Terminal Cash Flow): 202.48 x 0.751 = 152.06

Now we add up all the present value cash flows to get the Net Present Value or NPV. Doing this we get:
NPV = 166.62 + 159.09 + 152.06 = 477.77 crores

Now, the market cap of Graphite India Limited is currently 13,875.57 crores. A comparison with the NPV clearly shows that Graphite India Limited is clearly overvalued on an intrinsic basis given our assumptions and investment horizon.

Hope you find this example useful.

And all those who are looking to use this as an actual valuation on which to base their decisions, please remember that we assumed some of the inputs such as the cost of capital and investment horizon for ease of calculation, and hence these are just an example and not entirely accurate.

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Thanks @Akshay_Nayak. The example has clarified a lot.
The basic question is why 3 year perspective?
Some how I feel if you calculate for 3yrs the arrived value would be low and all stocks seem costlier.

Thanks once again.
Prasad.

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@Prasad_India I’m glad my example clarified a lot of your doubts. With respect to your contention regarding the three year perspective because of which the valuation is distorted, let me start by saying that your contention is absolutely right in essence. But, let me also remind you that I had just assumed a three year investment horizon for the sake of easy calculation and better conceptual clarity. When you apply this technique in practice, by all means, you can definitely use a 10-15 year investment horizon which will definitely give you a lot more realistic reflection of the intrinsic value.

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good work Akshay, How do you value companies with negative cash flow?.I guess in majority of the cases the companies in growth curve will have negative cash flows and that is the time share price double or triple as well…

In your formula, I think you need to bring perpetuity value that should be added to the discounted cash flow to arrive at true valuation

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@mukeshbhatt77 You bring up two very interesting and pertinent points. Allow me to deal with each of them individually.

Firstly with respect to companies with negative cash flows, the key to such a situation is that there has to be constant positive growth in cash flows, and there have to be disproportionately positive cash flows after the cash flows break even to make up for prior negative cash flows.

For example let us assume that there is a growth company with a presently negative cash flow of 100 crore with positive growth of 25 crore in cash flows per annum. Assume you have invested in this company with a ten year investment horizon.

Given the growth rate in cash flows, the cash flows will break even in 4 years as follows:

Today: -100
Year 1: -100 +25 = -75
Year 2: -75 +25 = -50
Year 3: -50 +25 = -25
Year 4: -25 +25 = 0

Now, you have to be confident enough in the future prospects of the company to believe that, starting with Year 5, (which would also begin the high growth period for the company in most cases), the company will be able to grow its cash flows at upwards of 25 crore per annum, say at 40 crore per annum to make up for prior negative cash flows in the first four years. If there is a more than likely chance that such growth can be achieved, it shows that the company is intrinsically undervalued. Such companies are usually highly priced in the market, because markets discount for the disproportionate future growth in advance.

Of course, if a company has negative cash flows without positive growth in them, it is usually best to stay away from such companies.

Coming to your second point regarding a perpetuity value, let us first look at what a perpetuity actually is.

A perpetuity is nothing but a certain periodic cash flow received at a certain discount rate for an infinite period.

When applied to companies, it means that we will receive a certain amount of cash flows periodically, over the entire life of the company. Now, it is virtually impossible to come up with an accurate estimate of the life of the company, because every company is invariably a going concern, so we assume the life of the company to be infinite.

With that said, in practice, we hold the stock of a company only for a certain period of time, which is a finite period.

But a perpetuity value discount rate is meant for an infinite period and it should only be used if we are confident of holding the stock over the entire lifetime of the company, which is practically impossible because most companies outlive us mortals, which is why it is popularly said that ‘men may come and men may go, but companies live forever’

Therefore, given that our investment horizon is a finite period, it is better to use a Terminal Value discount rate which is meant for discounting cash flows over a finite period, rather than using a Perpetuity Value discount rate, which is meant for discounting cash flows over an infinite period.

Hope you find this explanation helpful.

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Link to first part:

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Hi Akshay,

First off, A very Happy New Year. And, a big Thank you for the initiative to educative newbies like me. DCF had always puzzled me and continues to do so. In the response to Prasad above, you mentioned that Graphite seems overvalued. Does it seem only because of the time horizon and discount rate? or any other aspect. Can you please elaborate with another instance?

Now that we have estimated the FCFF figures, we discount the future FCFFs to their present values at the appropriate discounting rate, which is the cost of capital, which is 10%. Doing this we get:

Year 1: 183.3 x 0.909 = 166.62
Year 2 : 192.46 x 0.826 = 159.09
Year 3 (Terminal Cash Flow): 202.48 x 0.751 = 152.06

Now we add up all the present value cash flows to get the Net Present Value or NPV. Doing this we get:
NPV = 166.62 + 159.09 + 152.06 = 477.77 crores

Now, the market cap of Graphite India Limited is currently 13,875.57 crores. A comparison with the NPV clearly shows that Graphite India Limited is clearly overvalued on an intrinsic basis given our assumptions and investment horizon

Also since the cashflow statement has the 3 components CFO, CFF, CFI and finally Net cash flow, which of the component is to be used for the FCFF and how does one go about in the case of negative cash flow? Can you please illustrate with a live example?

Am challenged with regard to accounts and accounting and hence requesting. Thanks in advance.

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Dear Sir

Thanks for wonderful articles like these, I am not accounts person and get some takeaways for valuation from your articles.
I would also like you to cover how some Analysts predict Forward P/E ratios say FY 20 perspective etc and arrive at a FY20 cost and discounted price for a 3 year holding period etc. Again thanks for your useful articles.
Happy new year
Regards

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When you consider the cash flows for 3 years, you will have to include a value for disposing off the investment. Here by only looking at the cash flows, you are assuming that the company becomes worthless after 3 years. So to the final year cash flow you need add a value that is actual worth of the investment after 3 years for someone buying it from you.
As suggested it could be by assuming a perpetuity, but as you correctly assume, we are not going to hold till perpetuity. Alternatively it could be a value arrived at by assigning a terminal price to cash flow (or terminal PE). So one needs to make an assumption about the value of the investment after the investment horizon. We cannot assume it to be zero without a good reason.
For example, in case of Graphite India if the value today given by the market is > 13000 Cr, why would you assume it to be 0 after 3 years? Will it not continue to generate cash flows after 3 years? Can we try to assign some value for those cash flows?
We can again make some assumptions. For example, assume say 10 times the cash flow as a terminal value and calculate the present value of that. (477+1520=1997).
Alternatively, you can use the book value of the company (if it is liquidated) after 3 years.
If such a terminal value is not used, almost every investment will appear overvalued.

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@akbarkhan You are absolutely right sir. I had assumed a time horizon of three years for the purpose of easy calculation and better conceptual clarity. With respect to the calculation of a terminal value, the best way to do that would be to estimate the market cap of the company at the end of three years and discount it to present value.
For example, in the case of Graphite India Limited, assume the estimated share price at the end of three years is 1500. Also assume that there are 20 crore shares outstanding. That would bring the market cap of the company to 30,000 crore (Rs 1500 * 20 crore shares) Discounting this estimated future market cap to present value we get:
30,000 * 0.751 = 22,530 crore

This terminal value added to our previously calculated cash flow NPV of 477.77 crore gives us a net value of
22,530 + 477.77 = 23,007.77 crore

That means Graphite India Limited is worth 23,007.77 crore today. But it is selling on the market at a current market cap of 14420.67 which means it is clearly undervalued.

My apologies for not having thrown more light on terminal value calculation earlier. Hope you find this explanation helpful.

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Hi Akshay,

Shall be thankful if you could clarify my query too and help understand better. Thanks.

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I was reading this post Akshay, liked your simplicity of putting down thoughts. That will take you into right direction and success.

However those who are planning to use discounted cash flow as valuing company must realise few things:

  1. DCF is not customised method applicable to valuing shares. In other words DCF can be used any where which can give you free cash flow for certain years you want to use. It started with a fixed asset cash flow projection for capital budgeting purpose, the usages extended to project and finally company.
  2. Predicting free cash flow for a long period is as difficult as predicting GDP growth rate or inflation to long future. Even company themselves do not extend their forecasting more than 2/4 quarters. Largely due to such limitation rarely any financial institution relies on DCF.
  3. Capital expenditure plan or capex budget is prepared every year in a company as part of annual budget exercise. Replacement assets; yes company has an idea due to depreciation, payback period and useful life. That’s why DCF is popularly used in capital budgeting due to certainty in future numbers. Growth capital expenditure for 10 year means 40 mandatory board meetings plus another few hundred committee discussions. Next to impossible to estimate growth capex for a long shot. Faulty capex jeopardise the entire free cash flow resultants.
  4. Terminal value- companies are loaded with intangible these days, even thumb rule statutory depreciation are falling short, hence a impairment exercise is called every year. This is an absolute grey are which require high end expertise.
  5. Traditional DCF does not differentiate between a company having competitive advantage and a company do not. Earnings power beyond cost of capital can accelerate much faster due to the franchise nature.

This is just to bring sanity, of course nothing takes away your brilliant effort.

Best wishes

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@asvasanra First off, sorry for the delay in responding to your query. Allow me to address each of your queries individually

With respect to your query regarding the discrepancy in the valuation from a three year perspective, I have shown the correct calculation in my reply to @akbarkhan’s post.

With regard to your query regarding which cash flow to use when calculating free cash flow, it is always best to go with the net cash flow from operating activities, because free cash flow is aimed at finding liquid cash balances, and operating cash flows have the highest amount of liquidity since they are recurring in nature, as a result of which cash keeps getting turned over in the organization.

I hope you find this helpful.

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Yes. Thank you for the same.

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@Sandyboy First off, I am delighted to hear that you draw takeaway perspectives on valuation from my articles even though you do not have an accounts background. This is the most satisfying thing for me and shows that my efforts are worthwhile.

With respect to your query regarding forward PE ratios, analysts come up with these ratios based on something known as forward earnings.

When we carry out a regular PE ratio calculation, we make use of earnings figures from previous quarters gone by which are readily available to us, and these earnings are typically known as historical earnings.

Contrast that to a forward PE ratio calculation, where earnings for the next few quarters and expected stock prices are first estimated based on data currently available to us, using which a forward PE ratio is calculated.

I can’t delve too much into exact calculations owing a lack of availability of data and future earnings estimates, but I will still do my best to explain with an example.

Continuing with Graphite India Limited, its current stock price is 734.6 and current EPS is 10.48 so the current PE ratio would be:
PE ratio = Market Price/EPS
= 734.6/10.48
= 70.09
Now lets assume that the FY20 stock price is expected to be 1500 and FY20 EPS is estimated to be 31.44. The forward PE ratio would therefore be:

Forward PE ratio = Expected Market Price/Estimated EPS
= 1500/31.44
= 47.70

Notice that as EPS increases, PE ratio decreases, because strong earnings justify high valuations. There may be some cases where stock valuations are so high that PE ratios do not decrease despite an increase in earnings, which shows that the earnings may not have increased by enough to justify the high valuations.

Hope you find this explanation helpful.

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@The_Confused_Consult Thank you so much for your glowing endorsements and valuable pointers. Always a pleasure to hear from you. More to come from me on this space.