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DCF Technique
A and B are two oil exploration and production companies. A is a well established firm and has a net profit of Rs. 4000 crores. Its EPS is Rs. 20 per share and it is trading at a P/E of 10. B is a young company in the field and is yet to report substantial earnings. However, B has struck a new oil field the capacity of which is expected to exhaust not before 100 years. On the contrary, A has oil production capacity which is expected to last only the next decade. The shares of B are trading at a P/E of 30.
What do you make of this scenario? What's your take on the fact that the investors find stock B more attractive than A? Do you think this is a mispricing issue in the markets? Or have markets captured the worth of the company based on its future performance rather than current earnings?
Here's where the discounted cash flows evidences its relevance while valuing securities. The price one finds worth paying for a stock is not only a function of its past or current performance but also a function of the cash flows it is expected to generate in the future. Investors find stock of firm B more attractive because it is expected to generate cash flows for a long time in the future. This is not a mispricing issue. The value of a firm today is the cash flows it will generate in the future discounted with a suitable discount rate to generate its present worth. This worth reflects the intrinsic value of a business and helps in determining what the stock is worth paying for.
DCF is based on the premise that future cash flows from a security are the best way of computing its intrinsic value today. For instance, bonds future cash flows consists of interest and the face value. These can be discounted with the help of a suitable discount rate to arrive at a fair value of bond price. Similarly, in case of equity the cash flows considered could be dividends or free cash flow to equity. When we use dividends as cash flows and discount them with a suitable discount rate, it is known as dividend discount model. This is used when an investor primarily desires fixed income from the business. However, to estimate the future cash flows, an analyst also has to assume the dividend policy of the company. If the assumption goes wide of the mark, the valuation would be of little use.
A more commonly used DCF for valuation is free cash flow to equity approach. When we talk about free cash flow, it represents the cash flow from operations less the capital expenditures and interest and principal made available to the debt holders. It reflects the actual amount of cash available to investors after servicing the debt. To use DCF for analysis, one needs to decide on a time horizon and forecast the cash flows that the business will generate. If determining a finite time horizon is not certain because you don't know how long you will hold the stock as unlike bonds, stocks do not have a maturity date; a terminal value of the business is to be obtained. This terminal value is obtained by determining a certain growth rate at which the company is assumed to grow infinitely.
Any valuation primarily needs to incorporate two factors, time value of money and a risk-return relationship. In DCF analysis, this is reflected in the discount rate used to discount the cash flows of the business. Weighted average cost of capital (WACC) is usually used as the discount rate as the business is required to generate at least as much return as its cost of capital. WACC is primarily composed of cost of debt and cost of equity. Cost of equity can be found out by Capital asset pricing model. CAPM states,
Ke = Rf+ β(Rm-Rf)
Where Ke is the cost of equity
Rf is the risk-free rate
Rm is the market interest rate
β is the beta of the stock of the company
Cost of equity is higher than the cost of debt which is the tax adjusted interest rate. This is because equity investors are exposed to higher risk because of the uncertainty of the cash flows. Consequently, they require a higher return to compensate for the additional risk undertaken.
Computing DCF
DCF for a firm can be calculated as follows:
Value of a business: 
Where CF = free cash flow
The first part of the formula computes the present value of the cash flows of the firm till the finite period decided and second part of the formula computes the terminal value of the firm based on a perpetual growth rate assumed for the firm.
Interest rates and valuation of a business
From the above discussion, it is clear that valuation of a business can change with the change in assumptions of discount rate, perpetual growth rate and factors affecting cash flows such as sales, profit etc.
We would like to highlight effect of interest rates with respect to valuation of a business. If an analyst expects interest rates to move up, it implies increased interest servicing burden on the company and consequently lesser profits. Not only do interest rates affect cost of debt, it disrupts the required rate of return by the equity investors as well. This may be understood from the CAPM equation. As risk free interest rate rises, the return demanded by the equity investors also rises. With increase in both cost of debt and equity, the weighted average cost of capital of the firm rises. This has a direct effect on the valuation as increased discount rate discounts the cash flows to a lesser value.
Similarly, if an analyst believes that interest rates will fall, the interest servicing burden on the firm reduces and the required rate of return by the equity investors also comes down. This reduces the weighted average cost of capital of the company and hence the discount rate. This may be the case when the economy is expanding and the monetary policy is loosened to encourage investment. Here funds come cheap and therefore investors required rate of return reduces. In such a scenario, as the discount rate decreases, the value of a business increases on account of greater profits leading to better cash flows and decreased cost of capital of the firm. However, all this while we assume that the debt is a floating one. In case it is not floating, it will be only the cost of equity which would get affected by the interest rates movement. While interest rates may affect the stock prices, it is not the only factor affecting the stock price. A multitude of other factors will decide the stock price; however we are discussing the effect of interest rates on stock valuation using DCF independent of other factors.
As can be seen from the above table, the sum total of expected free cash flows from a business over the next 10 years is forecast at Rs. 2.1 crores. These future cash flows are worth Rs. 1.26 crores today, at a discount rate of 10%. Assuming there are 10,000 shares issued by this company, the fair value of each share works out to Rs. 1256.61.
Now, if interest rates in the economy rise (and assume there is no debt burden of this company which lowers the profits and free cash flows), the value of the share price should reduce anyway, as the discount rate goes up along with a rise in interest rates. An increase in the discount rate implies that the same future cash flows are worth less today. The discounted cash flows of this business now reduce to Rs. 1.14 crores from Rs. 1.26 crores, thus lowering the fair value per share to Rs. 1,139.16.
How does a fund manager use DCF techniques to pick stocks?
A fund manager can use DCF technique to determine the fair value of a firm. If the current market price of a stock is less than the fair value of the stock, it is underpriced and is a cheap stock for buying. However if the current market price of a stock is greater than its fair value arrived at by using DCF, the stock is expensive.
Also, with a forecast of interest rates, the fund manager can arrive at different values of a firm using sensitivity analysis and determining how much can the value of a firm change with a change in the interest rates. Depending on the mandate of the fund he manages, the fund manager can pick suitable stocks.
However, how much success a fund manager derives by picking stocks based on DCF valuations depends on his ability to correctly estimate and assume the discount rate, perpetuity growth rate and the future cash flows.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
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