Fundamental Analysis

Principle of DCF – Poonit Rathore

Listen to this article
Principle of DCF - Poonit Rathore
Principle of DCF – Poonit Rathore

14.1 – Share Price

In the previous chapter, we explained the first two steps of equity research. The first step is where we look at the company’s business and the second step is where we look at the company’s financial performance. The third step of equity research is to find out the valuation of the company’s shares. But that it Should be done when you are absolutely sure about the business of the company after the first two steps.

An investment is considered a good investment only when you pay the right price for that business i.e. you get those shares at a very good price. Sometimes instead of a very good company, if a medium company is also found at a very good price, then it is considered That be a very good investment. That being said, price plays a very important role in terms of investment.

In the next two chapters, we will try to tell you as much as possible about the price. We find out the price of the share by valuation technique. The meaning of valuation is to find out what should be the real value of the company. The technique we will use to find out the valuation of a company’s stock is called Discounted Cash Flow ( DCF). In this technique, the correct price of the company’s stock is estimated from the perspective of future cash flows.

There are many principles in the DCF model that are linked together. We have to understand all these principles separately and then look at them from the point of view of DCF. In this chapter, we will specifically look at the most fundamental principle of DCF i.e. Net Present Value ( NPV). After that, we will move to other principles and finally understand DCF.

14.2- Future Cash Flows

The basis of the DCF model is future cash flows. Let us understand this with an example :

Let’s say there is a pizza vendor named Vishal who makes the best pizza in town. He loves making pizza so much that he invented a new one – an automatic pizza maker. After putting all the necessary things in this pizza maker, pizza automatically comes out in 5 minutes. Vishal thinks that he can earn ₹500000 in 1 year from this pizza machine and the machine can run for the next 10 years.

Vishal’s friend George really likes Vishal’s machine and makes an offer to Vishal to buy it.

What price do you think George should pay Vishal for the machine? To find the answer to this question, we have to understand how much George can benefit from this machine. Suppose he earns ₹ 500000 every year from this machine for the next 10 years.

 What would George’s cash flow look like now : 

2015201620172018201920202021202220232024
500,000500,000500,000500,000500,000500,000500,000500,000500,000500,000

So we can see that for the next 10 years from 2015, George will continue to receive cash from the machine.

This means that George will earn ₹ 50, 00, 000 from the machine in the next 10 years i.e. he can not pay more than ₹ 50, 00, 000 for the machine. We cannot pay a price for anything that is more than the benefits we get from it.

Now suppose Vishal asks George for Rs X for the machine. Now there are two options in front of George, either he gives the demanded ₹ X and buys the machine or else he puts the money in a fixed deposit scheme where he will get the money back as well as an interest of 8.5% . . Suppose George decides to buy a machine, then his opportunity cost of not putting money in the fixed deposit is his opportunity cost.

In this attempt to find out the cost of an automatic pizza maker, we found out three things –

  1. The total cash flow of this machine in 10 years will be Rs   50, 00, 000.
  2. We know the total cash flow of this machine so the cost of the machine should be less than the total cash flow. 
  3. The opportunity cost of buying this machine is an investment that gives a return of 8.5%.

 Keeping these three things in mind let us move ahead because we know that George will get ₹ 500,000 per year from this machine for the next 10 years so it means that George will be able to see the future of the next 10 years in 2014. Trying –

  1. What will ₹500, 000 be worth in 2016? 
  2. What will ₹500, 000 be worth in 2018 as compared to today?
  3. What will ₹500, 000 be worth in 2020 as compared to today?
  4. Overall, what will be the value of the cash flow received in the future?

 The answer to these questions is hidden in the Time Value of Money. This means that if I can find the future monetary value of the cash flows today, it will be easier for me to work out the value of the machine.

 For the time being, we may move away from the pizza machine example, but eventually, we will return to this example.

14.3 – Time Value of Money ( TMV)

The time value of money is a very important principle, it is used in all types of financial theories, whether it is discounted cash flow analysis, financial derivatives pricing, project finance, annuity, or anything else. 

The principle of the time value of money is based on the premise that the value of money changes with time. This means that if you have ₹100 today, then after 2 years that ₹100 will be worth something else. As time changes, the opportunity cost also changes and that opportunity cost has to be linked with the value of money.

If we want to compare the value of money today with the value in the future, we have to take this money into the future and see its value. This method is called future value ( FV ). In the same way, if we want to see the value of money received in the future today, then we have to weigh that money according to today and this is called Present Value ( PV ).

In both cases, we have to add opportunity cost to the value of money as time changes. When we calculate the future value of money in this way, it is called compounding. Similarly, when the future value of money is calculated in today’s value, it is called discounting.

Now let us see the formula to calculate this FV and PV

Example 1 – What will ₹5000 today be worth after 5 years, if the opportunity cost is 8.5%?

In this example, the future value ( FV) would be :

Future Value Net Amount*(1 Opportunity Cost Rate)^Total Years

Future Value = Amount * (1+ opportunity cost rate) ^ Number of years.

= 5000*(1+8.5%)^5

= 7518.3

 This means that ₹5000 today will be worth ₹7518.3 after 5 years if the opportunity cost is 8.5%.

Example 2 – What will be the value of ₹ 10000 to be received after 6 years from today if the opportunity cost is 8.5 percent?

Here we are calculating PV.

Present Value = Amount (1 Discount Rate)^Total Years

Present Value = Amount / (1+Discount Rate) ^ Number of years

= 10,000 / (1+8.5%)^6

= 6129.5

This means that if the discount rate is 8.5%, then ₹10000 to be received after 6 years from today will be worth ₹6129.5 today.

Example 3 – If I change the question from the first example and ask what is the value of Rs 7518.3 due in 5 years today if the opportunity cost is 8.5%. We know that for this we have to find the present value. Also note that when we did this calculation in reverse in the first example, our answer was ₹5000. Calculating this, let’s  see PV :

= 7518.3/ (1+8.5%)^5

=5000

Now you understand the time value of money, so let’s go back to our pizza example.

14.4- The Net Present Value of Cash Flow

Let’s look again at the pizza example to see what kind of cash flow George is going to get after buying the machine.

2015201620172018201920202021202220232024
500,000500,000500,000500,000500,000500,000500,000500,000500,000500,000

Now the question is again the same – how much should the future cash flows be valued today? 

As you can see the cash flows are spread over the years in a similar manner. We have to discount this cash flow according to its opportunity cost or opportunity cost. 

Take a look at the table below in which the cash flows for each year have been discounted at an opportunity cost of 8.5% :

yearcash flowRs )Paymentyears)PV / Present ValueRs )
2015500,0001460,829
2016500,0002424808
2017500,0003391481
2018500,0004360802
2019500,0005332535
2020500,0006306485
2021500,0007282470
2022500,0008260,335
2023500,0009239,946
2024500,00010221151
Total50,00,00032,80,842

The number obtained by adding the present value ( PV) of each year is called Net Present Value or NPV. In this example, our NPV is ₹ 32, 80, 842 which means the net worth of the cash flows today is ₹ 32, 80, 842. It is clear that if George buys this machine, he should pay ₹ 32, 80, 842 or less.

Now, look at it from the perspective of a company. If this pizza machine was not a company, then how would you calculate its future cash flow, and based on that, how would you calculate the company’s share price? That’s exactly what we do in the Discounted Cash Flow model.

Highlights of this chapter 

  1. A valuation model like DCF helps us to know the share price of a company.
  2. The DCF model is based on a variety of financial principles.
  3. The time value of money is a very important part of financial theory, it is used in many things like DCF.
  4. The value of money varies with time. Today’s value of money changes in the future.
  5. To find out the true value of money, we have to look at money in terms of time and take into account its opportunity cost.
  6. In future value (FV) we find out the future value of money. 
  7. In Present Value ( PV), we find out the value of money received in the future at today’s price.
  8. In Net Present Value ( NPV), we find the value of the sum total of all future cash flows in today’s value.

14 comments

Poonit Rathore

My name is Poonit Rathore. I am a Blogger, Content-writer, and Freelancer. Currently, I am pursuing my CMA final from ICAI. I live in India.

Related Articles

Leave a Reply

Your email address will not be published. Required fields are marked *

Back to top button
en English
X
Don’t miss action in these stocks as they are likely to announce bonus shares!- Poonit Rathore Aaron Carter Biography – Poonit Rathore Daily Stock Market News Snippets- 6 November 2022 – Poonit Rathore Stocks to watch: These small-cap stocks will be in focus on Tuesday! – Poonit Rathore Daily Stock Market News Snippets- 31 October 2022 – Poonit Rathore Stocks to watch: These small-cap stocks will be in focus on Monday! – Poonit Rathore Nobel Prize 2022: All you need to know-Poonit Rathore How to Create an Online Course – Poonit Rathore Facebook – Success Story of the Meta-Owned Social Networking Site! Upcoming Switch games for 2022 (and beyond)-Poonit Rathore
Index
Don’t miss action in these stocks as they are likely to announce bonus shares!- Poonit Rathore Aaron Carter Biography – Poonit Rathore Daily Stock Market News Snippets- 6 November 2022 – Poonit Rathore Stocks to watch: These small-cap stocks will be in focus on Tuesday! – Poonit Rathore Daily Stock Market News Snippets- 31 October 2022 – Poonit Rathore Stocks to watch: These small-cap stocks will be in focus on Monday! – Poonit Rathore Nobel Prize 2022: All you need to know-Poonit Rathore How to Create an Online Course – Poonit Rathore Facebook – Success Story of the Meta-Owned Social Networking Site! Upcoming Switch games for 2022 (and beyond)-Poonit Rathore
Share to...