# Equity Research (Part 2) – Poonit Rathore

Table of Contents

**15.1 ****– Using DCF ****Analysis **

In the previous chapter, we talked about Net Present Value (NPV). NPV plays a very important role in the DCF valuation model. Now we need to understand some more principles related to the DCF model. We will apply the DCF model to Amara Raja Batteries Limited and understand the other concepts involved. By doing this, we will also understand the third step of equity research i.e. valuation method.

In the previous chapter, we tried to find out the cash flow based on the cost of the pizza machine and after discounting it, we calculated the PV. We calculate the Net Present Value ( NPV) by adding up all the present values. Along with this, we also tried to think that if the same thing is applied to the stock of a company instead of a pizza machine, then what would be known? The truth is that by looking at the future cash flow of any company, we can find out the price of that share. But what cash flow are we talking about? How can we know the future cash flow of the company?

**15.2 ****– ****Free Cash Flow ( ****FCF)**

The cash flow we use in the DCF analysis of a company is called **Free Cash Flow ( ****FCF)**. It is the cash that is left with the company after its capital expenditure i.e. capital expenditure, such as after purchasing land, building, or machinery. This is the amount that is kept for the shareholders. The hallmark of a good business is how much free cash flow it is generating.

So free cash flow is the amount that the company is able to save after all its expenses and investments.

If the company has free cash, it means that the health of the company is good. That’s why investors are always on the lookout for companies that are priced low but have strong free cash flows. They feel that in the coming time, the gap between share price and cash flow will disappear, and share price will go up according to good cash flow.

The formula to calculate free cash flow is :

**FCF = ****Cash From Business ****– ****Capital Expenditure**

**FCF = Cash from Operating Activities – Capital Expenditures**

3 year FCF of ARBL is calculated –

Description | 2011 -12 | 2012 -13 | 2013 -14 |

Cash from business activity ( after income tax ) | 296.28 crores | Rs.335.46 | Rs.278.7 |

capital expenditure | Rs.86.58 | Rs.72.47 | Rs.330.3 |

Free Cash Flow (FCF) | Rs.209.7 | Rs.262.99 | (Rs.51.6) |

Take a look at ARBL ‘s FY14 Annual Report and calculate the Free Cash Flow :

Note that income taxes have been taken out while computing net cash from operating activities. The score Net Cash from Operating Activities is highlighted in green and Capital Expenditure is highlighted in red.

Here a question may arise in your mind when we are extracting future free cash flow then why do we need to extract this historical free cash flow? The answer is very simple we have to predict future free cash flow in the DCF model. To do this we have to see what average the free cash flow has been growing historically till now and on the basis of that we can predict the future free cash flow.

Now the question is at what rate to predict the growth of free cash flow. Can it grow at a steady rate? It should always be kept in mind that its rate of growth should not be kept very high. Personally I always want FCF to be taken out for at least 10 years. To do this I predict a fixed rate for the first 5 years and then assume a lower rate for the subsequent 5 years. To understand it better, see the example below :

**Step 1 ****– ****Estimate Average Free Cash Flow**

First of all, let us take an average of the last 3 years of ARBL –

(209.7+ 262.99 + 51.6)/3

= **140.36 **

The advantage of taking the average of the free cash flow of the last 3 years is that we get an idea of the situation in every way and the effect of the ups and downs in the business is also removed. For example, the latest Cash Flow of ARBL was 51 . 6 crores which are negative. Obviously, this will not give a true picture of ARBL ‘s cash flow. That is why it is necessary to take the average free cash flow only.

**Step ****2 – ****Identify the speed of growth**

Take any rate of growth which you think is fair and reasonable and at which rate you think the average cash flow can grow. I usually divide the velocity of cash flow into two parts. I keep the first part for 5 years, and after that I keep the 5 years in the second part. In the case of ARBL, I assume a growth rate of 18% in the first 5 years, followed by 10% growth for the subsequent 5 years. If a company is doing well and has become a large company, I would probably go for 15% and 10%. The less you expect in your estimate, the better.

**Step ****3 – **** Estimate Future Cash Flows **

We know that the average cash flow of 2013 14 was 140.36 crores now with a growth rate of 18% the cash flow rate for 2014 – 15 will be estimated as :

= 140.36 *(1+18%)

= 165.62 crores

Free cash flow for the year 2015-16 will be :

= 165.62*(1+18%)

= 195.43 crores

Similarly, you can do further calculations also.

**Future cash flow estimation ****– **

serial number | The year | expected rate of growth | Future Cash Flow ( Rs . Crore ) |

01 | 2014 – 15 | 18% | 165.62 |

02 | 2015 – 16 | 18% | 195.43 |

03 | 2016 – 17 | 18% | 230.61 |

04 | 2017 – 18 | 18% | 272.12 |

05 | 2018 – 19 | 18% | 321.10 |

06 | 2019 – 20 | 10% | 353.21 |

07 | 2020 – 21 | 10% | 388.53 |

08 | 2021 – 22 | 10% | 427.38 |

09 | 2022 – 23 | 10% | 470.11 |

10 | 2023 – 24 | 10% | 517.12 |

You have a fairly good estimate of future price-free cash flow from us. But you may ask how accurate is this assumption. Lastly, in estimating free cash flow, we’re also estimating the company’s sales, expenses, business cycle, and all those things. That’s why this estimate of free cash flow is also just an estimate. That is why it is important that you be careful while estimating free cash flow, the less you estimate, the better. We have put here an estimate of 18% and 10%, which is very low for a good and growing company.

**15.3 – ****The ****Terminal ****Value**

We have tried to estimate the future free cash flow for the next 10 years. But what will happen to the company after 10 years? Will this company continue or not? A company is considered to be a thing that goes on continuously. This also means that as long as the company continues to operate, there will be some free cash coming in. But as the company gets bigger, the speed of free cash keeps on decreasing.

The rate of growth of a company’s free cash flow after 10 years is called the terminal growth rate. The terminal growth rate is generally considered to be less than 5%. Personally, I consider the terminal growth rate to be somewhere between 3% to 4%. The sum total of all future cash flows after 10 years is called terminal value. To calculate this, we have to multiply the 10th-year cash flow by the terminal growth rate. The formula to calculate it is slightly different :

**Terminal Value = ****FCF*(1 + ****Terminal Growth Rate) ****/ ( ****Discount Rate ****– ****Terminal Growth Rate)**

**Terminal Value = FCF * (1 + Terminal Growth Rate) / (Discount Rate – Terminal growth rate)**

Remember that the FCF here is for the 10th year. Now let us calculate the terminal value of ARBL at a discount rate of 9% and terminal growth rate of 3.5% :

= 517.12*(1+3.5%)/(9%-3.5%)

= Rs 9731.25 crore

**15.4 – ****Net Present Value ( ****NPV)**

Now we also know the 10-year future free cash flow and we also know the terminal value (which is ARBL ‘s free cash flow after 10 years to infinity). You need to find us the value of this free cash flow at today’s price. You will remember that this is what we call present value. If we have taken out the present value, then we will be able to take out the net present value as well.

For this, we assume a discount rate of 9%.

For example, ARBL to be received at 195.29 in 2015 – 16 at a discount rate of 9%, its present value would be :

= 195.29/(1+9%)^2

= Rs 164.37 crore

The present value of future cash flows will be as follows :

No | The year | rate of increase | Future Cash Flow ( Rs. Crore ) | Present Value ( Rs. Crore ) |

1 | 2014 – 15 | 18% | 165.62 | 151.94 |

2 | 2015 – 16 | 18% | 195.29 | 164.37 |

3 | 2016 – 17 | 18% | 230.45 | 177.94 |

4 | 2017 – 18 | 18% | 271.93 | 192.72 |

5 | 2018 – 19 | 18% | 320.88 | 208.63 |

6 | 2019 – 20 | 10% | 352.96 | 210.54 |

7 | 2020 – 21 | 10% | 388.26 | 212.48 |

8 | 2021 – 22 | 10% | 427.09 | 214.43 |

9 | 2022 – 23 | 10% | 470.11 | 216.55 |

10 | 2023 – 24 | 10% | 517.12 | 218.54 |

Net Present Value (NPV) of future cash flows | Rs.1968.14 Crs |

Along with this, we have to find out the Net Present Value for Terminal Value as well. For this, we have to discount the terminal value by the discount rate.

=9731.25/(1+9%)^10

= Rs 4110.69 crore

Thus, the total present value of the cash flows will be :

= 1968.14+ 4110.69

= Rs 6078.83 crore

This means that from here today we can see that ARBL is going to generate a lot of free cash flow in the future. That is, the shareholders of ARBL will get Rs 6078.83 crore.

**15.5 – ****Share Price**

Now we have come to the end of the DCF analysis, so now we will calculate the share price of ARBL based on future free cash flow.

We know the total free cash flow ARBL is going to generate, and we also know the total number of outstanding shares of ARBL, and the total free cash flow divided by the total number of shares will give us the price per share of ARBL.

But before doing this, we also need to know the net debt of the company. We will get this figure from the balance sheet of the company. To arrive at this, this year’s total debt has to be subtracted from this year’s cash and cash equivalents.

**Net Debt ****= Total Debt for the year **– **Cash ****and Cash Balance**

**Net Debt = Current Year Total Debt – Cash & Cash Balance**

Net debt of ARBL (as per FY14 balance sheet) –

Net Debt = 75.94-294.5

= (Rs 218.6 crore)

A negative number means that the company has more cash than debt. Now, this has to be added to the total present value of the cash flows.

= 6078.83 – (218.6)

= Rs 6297.43 crore

Dividing this number by the total number of shares, we will get the share price of the company. It is also called the intrinsic value of the company.

**Share Price = Net Present Value of Free Cash Flow ****/ ****Total Number of Shares**

**Share Price = Total Present Value of Free Cash flow / Total Number of shares**

According to the annual report of ARBL, the total number of shares of the company are 17.081 crores. Hence the intrinsic value of the company is :

6297.43/ 17.08

= **Rs ****368 ****per share**

In this manner, the DCF model is used.

**15.6 ****– ****Modeling Error ****and the ****Intrinsic Value Band**

The DCF model is made scientifically but it works on the basis of many assumptions. So there is always a possibility of some mistakes in it. Therefore, it should be assumed that we must have made some mistakes in our estimates, and only after correcting those mistakes, we should look at the intrinsic value. In order to reduce the effect of errors, the intrinsic value can be viewed as a band. Personally, I take a 10% upside and 10% downside in the intrinsic value of the stock.

If you look at your calculation above and plug this formula into it :

Lower band of intrinsic value will be = 368*(1-10%) = Rs 331

The upper band of intrinsic value will be = Rs 405

Thus, instead of assuming the intrinsic value of the stock to be Rs 368, I would consider the price to be between Rs 331 and Rs 405.

Keeping this price band in mind, let us look at the market price of the stock. From which we know that :

- If the stock price is below the intrinsic value band, it means that the stock is undervalued. In this case, the stock should be bought.
- If the stock price is in between the upper band and the lower band, it means that the stock is well priced and there is no need for fresh buying at this price. You can hold the shares if you want.
- If the market price of the stock is above the upper band of the intrinsic value, it means that the stock is getting expensive. In such a situation, the investor should either book profit or stay in the stock. In such a situation, one should not buy at all.

Keeping these things in mind, let us have a look at the price of Amara Raja Batteries Limited as displayed on the NSE website on December 2, 2014.

We can see that the stock is selling at ₹ 726.70 which is well above the intrinsic value band of the stock. It is clear that buying the stock at this price would be buying it at a very high valuation.

## **15.7 ****– ****Identifying Buying Opportunities**

Long-term investing is like a slow-moving train whereas active trading is like a fast-moving bullet train. That’s why when a long-term investment opportunity arises, it remains in the market for some time, it does not disappear suddenly. For example, we know here that the share of Amara Raja Batteries Ltd. is overvalued, that is, it is being sold at an expensive price. A year back, the same stock was available at a different price. Look at the chart and remember that the intrinsic value of ARBL stock has a band of ₹331 to ₹405.

In the blue highlighted portion, you can see that the stock remained in its intrinsic price band for 5 months. If you had bought this stock at that time, all you had to do was forget about the stock and now you would be sitting on a handsome return.

Perhaps that is why it is said that many things are available at a good price in a bear market or bear market. You must remember that in 2013 the market was in a bearish phase.

**15.8- **** Conclusion ****_**

In the last 3 chapters, we have looked at different dimensions of equity research. You must have understood that equity research means looking at the company in three different phases.

In the first step, we look at the quality of the company. In this, we look at the company from the questions like when, why, and how. According to me, it is very important at this stage of equity research if you are not satisfied with the quality of the company then don’t proceed further. Remember that there is no dearth of opportunities in the market, so there is no need to forcefully remove any opportunity.

After being completely satisfied with the results of the first phase, we move to the second phase where the performance of the company has to be seen. For this, I have made a checklist and shown it to you. That’s my checklist and I think it’s a good checklist. But I expect you to make your own checklist and build it on the basis of your reasoning.

The last part of equity research is followed by the third step in which we look at the intrinsic value of the company and compare it with the market price of the stock. If the market price of the stock is less than the intrinsic value, then it is clear that it is a good time to buy the stock. If all three steps satisfy you, then it means that you have got all the information about the stock and you have made up your mind. Once you buy a stock, stick to it and don’t get bothered by the day-to-day ups and downs.

I have created an excel sheet of ARBL ‘s DCF model which you can **download** from here and based on this you can calculate for other companies as well.

**Main points of this chapter**

- To get the free cash flow of the company, we have to subtract the capital expenditure or capital expenditure from the cash received from the business activities.
- Free cash flow tells us how much money the company is saving for its investors.
- Based on the free cash flow of the current year, the free cash flow for the coming years is predicted.
- It is better to keep your estimate of the rate of growth of free cash flow low in your forecast.
- The terminal growth rate is the rate at which a company’s cash flows grow after the terminal year.
- Terminal value is the value at which the company’s cash flows grow to infinity from the terminal year onwards.
- Both future free cash flow and terminal value have to be discounted to today’s price.
- The sum total (including terminal value) of all the discounted cash flows is called the net present value of the cash flows.
- After deducting the total debt from the total net present value of cash flows, if we divide it by the total number of shares, we will get the intrinsic value of each share of the company.
- After working out the intrinsic share price, we should take into account the modeling error in it, for this, we can make a band of 10%
- This 10% band is called the intrinsic value band.
- A stock priced below this band is a good buy while a stock priced above this band is considered expensive.
- Your wealth grows by buying undervalued stocks
- This means that DCF analysis tells investors whether the stock is a good buy at the current price or not.