Warning: Garbage in, Garbage out
DCF is a very powerful tool for valuing stocks. However, this methodology is only as good as the inputs.
For example, even a small change in inputs (like growth rate or discount rate) can bring large changes in the estimated value of the company. (Try changing these values by 1% or 2%- and you can notice a significant change in the result). In short, if the inputs are not reasonable, the out will also not be correct -'Garbage in, garbage out'.
Therefore, fill all the inputs carefully as they all have the potential to erode the accuracy in the estimated intrinsic value.
How does this DCF Calculator work?
- First, you need to enter the current year Free cash flow (FCF) of the company. The DCF model takes the yearly FCF and projects this over 10 years into future by multiplying it with the expected growth rate (please assume a realistic growth rate for the company).
- Next, it calculates the net present value (NPV) of these cash flows by dividing it by the discount rate. The calculator takes the NPV of the FCF from each of these 10 years and adds them up.
- The last year FCF is multiplied by the terminal factor (usually between 7 to 12) to find the terminal or sell-off value of the company and added to the original calculations. (Read more about discounted terminal value here).
- Finally, net cash and debt available on the company’s financial statements are adjusted in the calculations to arrive at the market value estimate of the entire company.
- When you divide this value with the total number of outstanding shares, you will get the intrinsic value per share of the stock.
(You can read more regarding DCF Valuation here.)
Let’s calculate the Intrinsic value of Hindustan Unilever Limited (HUL) using the Discounted Cashflow Valuation method. (Please note that all the data used here has been gathered from Yahoo Finance.)
- First of all, we will start by finding the free cash flow of HUL, which is the first component of the DCF Calculator. Here, we’ll take the FCF for the last 3 years and consider their average as a reasonable FCF. Now, free cash flow is equal to cash from operating activates minus the capital expenditures. The FCF for the last three years turns out to be Rs 5,176 Cr, Rs 4,072 and Rs 3,361 Cr. The average FCF for last 3 years is (Rs 12609 Cr/3) = Rs 4,203 Cr. (Source: Yahoo Finance, See: Financials--> Cash flow)
- Next, we don’t want to project this free cash flow for infinity. We’ll project this FCF only for the next ten years. Although, the company may continue for many more years after the tenth year, however predicting free cash flow for over 10 years is really difficult. Therefore, we assume that the company will sell off all its assets at the end of year ten at a ‘Sell off valuation’. We’ll use a multiplier of 12 for the tenth year cash flow to simulate the value of these cash flows in the case company would sell all its assets (This is a necessary assumption that we need to make in order to find the value of the company).
- Apart from the cash flows, the next important input is cash and cash equivalents which the company reflects on its balance sheet. For HUL, this value is equal to Rs 3,345 Cr. (Source: Yahoo Finance, See: Cash and cash equivalents and short-term investments).
- Besides cash, the next essential input is the debt (as debts have to be first paid off and shareholders are last in the line). Hindustan Unilever is a debt-free company with zero long-term debt. (Source: Yahoo Finance, See: Long-term debt).
- Next, we need to find the annual growth rate for Hindustan Unilever. Analysts estimate that HUL will grow at 16.20% per annum for the coming five years. However, as we are predicting for a longer time frame, let’s take a safety of 20% on the growth rate. This yields a conservative growth rate of 12.96%. (Source: Yahoo Finance, See: Growth Estimates (Next 5 years).
- Further, just as our fair value calculator assumptions, let’s take a 10% discount rate.
- In addition, we need the total numbers of outstanding shares. It is equal to 216 Crores. (Source: Yahoo Finance, See: Share statistics)
- Finally, let’s take a margin of safety of 10% on the overall calculated intrinsic value.
After placing the above values in the DCF Calculator, the true intrinsic value per share of HUL turns out to be Rs 490.73 (after a margin of safety of 10% on the final intrinsic price). This is the intrinsic value estimate per share for Hindustan Unilever at the time of writing using the DCF model (Sept 2018). The current stock price of HUL is at Rs 1557. This means that this stock is overvalued by over 200% currently.
Quick Note: Although this stock may ‘NOT’ be under-priced currently. However, there are thousands of listed companies in the Indian stock exchange. If you keep looking for great companies, you’ll eventually find good companies which are trading at a decent valuation. Nevertheless, do not overpay for purchasing any company. As Benjamin Graham (father of value investing) used to say- "A good company is not a good investment if you overpay for it". Happy Investing.
- What is Free Cash Flow (FCF)? Explained in Just 1,000 Words.
- A Complete Guide on Enterprise Value and Equity Value.
- Valuation Basics: What is the Time Value of Money (TVM)?
- How to read the financial statements of a company?
- How To Select A Stock To Invest In Indian Stock Market For Consistent Returns?
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