In all my posts on investment ideas, I typically refer to the instrinsic value of the company. Although the definition and the concept is deceptively simple, application takes a lifetime.

What is intrinsic value – It is the total free cash flow the company will produce from now to closure of the firm. Discounting these cash flows gives the intrinsic value.

I will not be able to give a complete rundown on the DCF (discounted cash flow) computation. That could be another post, when I am really in mood to bore everyone to tears :). However the formuale for the computations is present in my valuation template – see the tab ‘DCF’

You can find the formulae here. The key parameters are free cash flow, discount rate, terminal values and growth rate. There are volumes written on each parameter and I will not get into the pros and cons of it. Let me give you how I calculate each. You can find the mechanics for each in my worksheets for companies.

Free cash flow = Net profit (after adjusting for all one time gains / losses) + depreciation – maintenance capex

Discount rate = around 12-13 %. That’s the hurdle rate for me. I don’t use any risk premium above that. Discount rate is a research topic in itself. I prefer to use a rough approach though and not tie myself up in academic acrobatics.

Growth – self-explainatory

Terminal value – It is the value of the company from the nth year ( n-1 year are the no. of CAP years) onwards. I would suggest looking at some textbook for more details as it is difficult to explain it in a short post.

I take it as 12 times Free cash flow of the previous year. Simple formulae for terminal value is NOPAT (net operating profit after tax)/ WACC (weighted average cost of capital). However let me warn you that the DCF calculations are very sensitive to the terminal value and it is important to be conservative on this parameter.

Once you have worked these numbers, you can plug them into a spreadsheet and get the intrinsic value. As you can see all these numbers are estimate and hence intrinsic value is an estimate too. The trick is in the assumptions you make. You have to be careful in making conservative assumptions, otherwise the DCF calculation could give you inflated numbers. That’s why a good valuation requires an indepth understanding of the company and its economics.

Discounted cash flow (DCF) analysis is the most fundamental way of calculating the instrinsic value. The other approaches such as PE, relative valuation which depends on comparing the valuation with other companies in the same industry etc are indirect valuation approaches. They can be used an input into the valuation process, but should not be the sole approach

## 9 comments:

Dear Rohit,

Free cash flow = PBDIT+ depreciation – maintenance capex

This seems to be incorrect.

FCF= PAT+deprn-maint capex

If you wish to use a PBDIT based formula, you could use

FCF= CFO- maint capex.

But the formula you give double counts depreciation.

Hi

yes your are right. the formulae is correct in the link, but put an incorrect one in the post. thanks for pointing that out

regards

rohit

Sorry if this sounds naive, but why doesn't the calculation for intrinsic value include the book value of the company? If you look at the common stock as a shared ownership of a company, then the value of the company ought to be the current book value of equity

plusthe future cash flows of the company discounted to the present. What am I missing here?A couple of more naive questions:

1. How

canyou reasonably arrive at the expected growth rate of a company when it ought to depend on future conditions of the world economy, Indian economy, the relevant industry sector, the fate of the company, etc.? That's a lot of crystal-ball-gazing for my comfort.2. How do you arrive at an appropriate discount rate? From my understanding of present value calculations, it should be something close to what you can invest in relatively risk-free instruments like government bonds, but the values you are recommending are a bit on the higher side.

Thank you in advance for taking the time to answer my questions.

Hi mathew

i have not really used this formulae. i think the reason you dont use book value is because the cash flow considers the effect of book value. the assets representing book value are generating those cash flows. what you may add is the excess capital such as cash over an above the regular assets.

regarding growth, you can never be sure as you rightly said that it depends on multiple factors. thats the reason you should consider a range of possible growth and assign probabilities to each and use that to average at a blended value. that is fairly subjective and unfortunately there is no precise way of evaluating growth. however in some case even under very pessimistic growth assumption the intrinsic value is far in excess of the current price.

you will use hurdle or discount rate as risk free bonds if that is your hurdle rate or opportunity cost. If you consider that your hurdle rate or opportunity cost is higher , then you can use a higher rate. this is not exactly as per the finance text books, but it serves as a good approximation.

hi rohit,

..could it be that we need to take into account capex for growth oppurtunities? ..it seems strange to assume growth but calculate free cashflow with no consideration for growth capex.

anon

Rohit,

I find book value of stocks like Rel Power very high even thoug their operations do produce any cash. I think it is because of the reserves that got filled with premium money on the equity capital raised. Your thoughs

Hi .

Do you belive in Value investing, i.e investing in a company which have good growth history in earnings, ok types balance sheet, but a terrible stock pricing history.

Please have a look on Compact Disc India, which has a P/E around 0.91 and Growth rates between 30% y-o-y.

Waiting for your comments..!

Hello Rohit,

Can you share the valuation Template please?

I could not find that in above group.

Thanks

Vijay

Hi Rohit,

Could you share the valuation templates mentioned in your post. They are no longer available on the google group.

Regards,

Trupti

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