Stock Valuation Using Discounted Cash Flow Model

The year 2008 is over and we have entered 2009 with lots of expectation as we hear of many packages from the government to boost economic growth. A normal investor will be perplexed by the volatility in the market and will be in search of methods to help him select stocks in such market conditions. In the previous issue, we had discussed the method of picking stocks trading below their respective book values, and stocks having low debt-equity ratio. In this issue we will discuss the use of Discounted Cash Flow model or the DCF model in picking stocks. DCF model takes into account the time value of money. Due to inflationary pressures, the value of a unit of money changes as time passes by. According to this model, what we are able to buy with a certain amount of money will not be available at the same price after a few years. Therefore, the calculation of the present value of future cash flow is very important to obtain the true value of a firm. In this method, both the cash inflow and cash outflow are discounted at a discount rate which is often the cost of capital. After a few years the discounted factors narrow down. In this way we can discount the money earned in the future in two different ways. The first one is the inflow and outflow of a single amount, while the second one involves a number of inflows and outflows over a period of time.

The generally accepted formula used to compute the present value of future cash inflow or outflow is

Where PV = Present Value

Ct = Cash flow at time’t’

r = Interest Rate

t = Time

The example explained below will give a clear picture as to the calculation of Present Value. The estimated Earnings after Interest and Tax of XYZ company for the coming five years is as follows:-

In order to calculate the PV, we must first know the discount rate which is generally the cost of capital of the company. Suppose the cost of capital is 12%, then the discount factors for the coming five years will be:

(Discount factor is found using the formula = 1/(1+r)t)

On applying the formula we get:

PV = (150*0.892857) + (175*0.797194) + (200*0.71178) + (250*0.635518) + (290*0.567427) = Rs739.23 crores

On comparison with the cumulative earnings for the coming five years which will be at Rs 1065 crores, we can see that the value of the money has eroded 30.58% over the given period of five years.

Suppose the paid up capital of the company XYZ is Rs 60 crore which is distributed among 60 lakh shares of Rs 100 each. The present market price of the shares of the company is Rs 190 making the stock market value of the company at Rs 114 crores. This amount is much below the present value of the expected earnings of the company calculated earlier, and hence the market price of the shares of the company is justifiable. If the market price of the share shoots upto Rs 1850, the market capitalization will be Rs 1110 crore as against the present value of the company which is calculated to be Rs 739.23 crore.

This calculation of the present value of the future earnings of a company will help the investors to take a decision as to whether to go in for the stock or to stay away it. The investors can enter the stock if the present value of the future earnings of the company is below the cumulative future earnings. They should think twice if the present value of future earnings is greater than the cumulative future earnings of the company.