Warren Buffett wrote in his 1992 letter to shareholders of Berkshire Hathaway…

In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

What Buffett defines here is essentially what we know as the discounted cash flow or DCF, a key method to calculate intrinsic value of companies.

The interesting thing to note here is that no one knows whether Buffett has ever used DCF himself!

Even Buffett’s business partner and alter ego Charlie Munger has occasionally said that he has never seen Buffett doing any DCF calculations.

In fact, this is what Buffett wrote in his 2002 letter…

Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investments are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas.

Anyways, despite his secretiveness, Buffett has been vocal about the importance of DCF several times in the past.

But if you were to believe a majority of security analysts out there, they will tell you to simply avoid DCF. The reason they give is that DCF is dependent on 5-10 years of future cash flows, predicting which is highly uncertain.

So they use relative valuation multiples like price to earnings, price to book value, or EV/EBITDA (which are also based on predictions!).

But you must recognize the simple fact that multiples are not valuation. In fact, multiples are simply shorthand for the intrinsic valuation process, which must generally be based on the DCF method.

You must never confuse the two – multiple based valuation and intrinsic valuation.

Of course, doing a P/E based valuation of stock can save you a lot of time and hard work (and that’s why most analysts use this). But it will be merely a case of garbage in-garbage out.

In fact, the simplicity of such ratios is a sign of inaccuracy, not accuracy. As Keynes said, “It is better to be vaguely right than precisely wrong.”

**DCF: Problems and solutions**

If you were to go through the DCF calculation excel, there are three key variables you need to calculate the DCF value of a company:

**Estimates of growth in future free cash flows (FCF):**Growth in FCF over say the next 10 years, using last 3 years average FCF as the starting point. (Click here to see the calculation of FCF from a company’s cash flow statement)**Terminal growth rate:**Rate of growth in FCF after the 10th year and till infinity.**Discount rate:**Rate at which the future cash flows must be discounted to bring them to present value.

Now there are three key issues that arise with these variables:

- What growth rate to assume for future FCF estimates?
- What discount rate to assume?
- What terminal growth rate to assume?

Let me help you with how do I answer these questions for calculating DCF valuations myself.

**1. How do I predict future FCF?**

As an analyst, I always found it difficult to predict growth rate in volumes, sales and profits. But I still tried to do that – after all, I was paid to predict the future!

However, as I’ve realised over the years, trying to find a perfect answer to the question “What growth rate to assume?” is like trying to find a “perfect couple”. None exist! 🙂

Given this limitation of trying to predict the future, I’ve changed my way of analysis to value stocks based on the present data rather than what will happen in the future.

That’s why I now don’t try be accurate with my FCF growth estimates. I just try to be reasonable and use common sense.

For most stocks, I generally perform a 10-year 2-stage DCF analysis. What this means is that I assume a particular growth rate for the first five years of my FCF calculations (as you can see in my DCF excel), and then another number for the next five years.

I rarely go above 15% annual growth rate for the first five years, and 8% for the next five.

The best practice is to keep growth rates as low as possible.

If the company looks undervalued with just 5% annual growth in FCF over the next 10 years, you have more upside than downside.

The higher you set the growth rate, the higher you set up the downside potential.

To repeat, while assuming FCF growth rate for the future, just be reasonable and use common sense.

A caveat – don’t take cues from the past as the past performance is rarely repeated in the future.

**2. How much discount rate do I assume?**

In simple words, discount rate is the rate at which you must discount the future cash flows (as estimated using above growth assumptions) to the present value.

Why present value? Because we are trying to compare the company’s intrinsic value with its stock price “now”….in the present.

Just to help with an example, what price would you pay for an investment today if company ABC’s future cash flow is worth Rs 1,000 after 1 year?

- If the discount rate is 5%, you must pay Rs 952 now (1000/1.05).
- If the discount rate is 10%, you must pay Rs 909 now (1000/1.1).
- If the discount rate is 15%, you must pay Rs 870 now (1000/1.15).

In other words, the higher the discount rate you assume, the lower you must pay for the stock as of now.

Finance textbooks and experts would tell you to use Capital Asset Pricing Model (CAPM) to calculate discount rate. I used CAPM myself to arrive at discount rates in the past.

However, if you are worried what CAPM is, don’t be because you can avoid knowing about it and still live happily ever after….like I am living. 🙂

Look at discount rate as the “annual rate of return” you want to earn from the stock.

In other words, if you are looking to invest in a business that has comparatively higher (business) risk than other businesses (like in case of most mid and small cap stocks), you may want to earn a 15% annual return from it.

For valuing such businesses, take 15% as the discount rate.

In case of relatively safer businesses (think Infosys, HUL, Colgate), earning around 10-12% annual return over the long term is a good expectation (because these businesses will also provide some stability to your portfolio during bad times).

For valuing such businesses, take 10-12% as the discount rate.

Better still, assume a constant discount rate for all companies. I am gradually turning to this model – of taking a constant 12% discount rate for all kind of businesses (safe or risky).

“But this way, how would you adjust for the risk in each business?” you may ask.

Simple – adjust the risk in FCF growth estimates. That is where the real risk lies, right?

**3. How much terminal growth rate do I assume?**

As I mentioned above, I do a 10-year FCF calculation for arriving at a stock’s DCF valuation.

But the companies I’m valuing won’t cease to exist after 10 year. Some will survive for 10 more years, some for 20 years, and very few for 50 years.

That is where the concept of “terminal value” (or the value after 10th year and till eternity) comes into picture.

The terminal value I generally assume lies between 0% and 2%. Assuming higher terminal value (>3-4%) is like assuming the company to grow bigger than the world economy in the infinity, which isn’t possible.

So the idea is to keep it as low as possible. Best to keep it at 0%.

**Voila, I got a perfect intrinsic value!**

No sir! Even after being reasonable and using common sense in assuming FCF growth rate, terminal growth rate and discount rate, there is 0% guarantee that you will arrive at a “perfect” intrinsic value using DCF (or for that matter, using any intrinsic value method).

Believe me, however reasonable, realistic, rational (whatever you may want to call it) you get in calculating intrinsic values, you are bound to go wrong.

This is for the simple reason that you are still trying to predict the future…which is unpredictable.

Now what to do?

**Hey, you forgot “margin of safety”?**

Valuation is an imprecise art (yes, however smart you may think you are!). Also, the future is inherently unpredictable.

Thus, it’s important to bring in the most-important investing concept of “margin of safety” into the picture.

This is what Graham wrote about margin of safety in *The Intelligent Investor*…

Confronted with the challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

Margin of safety is simply the discount factor that you use with your intrinsic value calculation. So if you arrive at an intrinsic value of Rs 100 for a stock that trades at Rs 80, you might think that you have found a bargain.

But what if your intrinsic value calculation is wrong? Yes, it will be wrong, at least 100% of the times!

Thus, you will do yourself a world of good by buying the stock only at say 50% discount to your intrinsic value calculation, or around Rs 50.

Image Source: Stockbullets.com

Now when you bring your intrinsic value assumption down to Rs 50 – by giving a 50% discount to the original calculated value of Rs 100, don’t think that you are trying to be ultra-conservative.

What you are doing is providing yourself protection against:

- Bad luck
- Bad timing, and
- Bad judgment.

As simple as that!

Margin of safety was, and will always be, the bedrock of value investing.

You can’t ignore this at any cost…or it will turn out to be a costly affair!

**So, never ignore the power of DCF…**

The DCF model can provide a useful valuation estimate if you follows these simple principles:

- Invest in companies with business certainty – financial stability, business predictability.
- Invest in companies with sustainable competitive advantage.
- Do the hard work of analyzing past financial statements (over at least a 10-year period).
- Use conservative assumptions of FCF growth of around 10-15%, terminal growth rate of 0-2%, and discount rate of 12%.
- Use margin of safety to protect against bad luck, bad timing, and bad judgment.
- Be honest by not modifying your original assumptions just because you “like’ the stock but DCF is saying otherwise.

That’s about it!

Or is it?

**Let’s do “Reverse DCF”**

Most of you must have not heard of the concept of “reverse DCF”.

Don’t worry, it’s not that complex a subject that the name might suggest! You do a “reverse DCF” by *reversing* just one assumption in your original DCF calculation – the FCF growth rates.

The aim of reverse DCF is to get the intrinsic value to match the stock’s current price – to find out what’s the FCF growth estimates the stock market is pricing in the stock.

Let’s understand this with an example. Colgate’s current stock price is around Rs 1,230. However, assuming FCF growth rates of 10% (for 1-5 years) and 8% (for 6-10 years), we arrive at an intrinsic value of Rs 398.

Now, we need to tweak the FCF growth rates in such a way, that this Rs 398 rises to around the current stock price of Rs 1,230.

Just try that on your own – calculations will show that when you raise the FCF growth rate to 26% for both the 5-year periods, the stock’s intrinsic value will rise to Rs 1,233…or almost near the current price.

What this indicates is that the stock market is currently pricing Colgate at a level that is justified only when the company can grow its next 10-years’ FCF at an average annual rate of 26%!

Now you need to answer whether such a long-term growth rate is realistic and achievable. Or whether the market has irrational expectations from Colgate’s business.

Just for your information, Colgate has grown its FCF at an average annual rate of 16% over the past 8 years. So a 26% growth rate over the next 10 years really looks on the higher side.

But as an investor, you must take a call on that!

That’s all I have to discuss on the subject of DCF as of now. I would like to leave you with the link to a very good resource – The Dangers of DCF – written by James Montier in 2008.

Finally, an important quote from a noted statistics professor, George E P Box – *“All models are wrong; some are useful.”*

So learn about DCF, use it, but expect to be wrong!

All the best!

shankar says

This is a real gem Vishal….You have explained it so well that anyone can understand about DCF…:)

Vishal Khandelwal says

Thank you Shankar!

Sunny says

Thanks Vishal

Indeed nice written. Btw, I’ve recently seen something – if we assume constant 2% growth rate, a very simple and conservative model comes – Average FCFF for last three or five years / (0.15 – 0.02)…and I feel doing this terminal value only DCF doesn’t give a very different number – after all, terminal value is the biggest component, at least 60% or so…so we have an inherent MoS in this analysis, and we don’t need to worry about growth rate – we get growth for free (anything above 2%)

What do you think about it?

Vishal Khandelwal says

Hi Sunny, what you are proposing is similar to the dividend discount model that assumes growth in dividends. Anyways, when you say – “we don’t need to worry about growth rate”, well you are still assuming a 2% growth rate. Also, when you use this as the constant number, then you may end up overvaluing some companies (with not so good FCF growth), and undervaluing others (with better than average FCF growth).

Sunny says

Thanks Vishal. Of course, 2% is just a number…I’d rather do this – if the average growth rate for last 5 years has been less than 5%, I’d assume 0% terminal growth rate, and only if past growth rate is more than 5%, I take 2% terminal growth rate, for past growth b/w 5-10%, take 1%….

Just some empirical numbers, I know…but then we simplify the model, eliminate the uncertainty in one of the variables…

The question is, does this method inherently have margin of safety? For fast growers, there’s a bigger MoS while a smaller MoS for slow growers…I don’t know, off late, I’ve realized that simpler the valuation method, the better – something that “will” go wrong should have lesser importance, and we should be more conservative about it…just a “realization”…what do you think 🙂

anil1820 says

Hi Vishal

Another great article. Infact reverse DCF is one of the greatest tool to know what is being factored by market. But I do not agree to your 15% discount rate suggestion. I agree its conservative but may be too conservative. The way I look at the whole thing is 1) First of all as value investors we omit lot of business which do not provide certainty of cash flow like technology company or pharma companies or retail companies 2) Our cash flows estimates are already conservative. Infact I am fine even if we would like to take CF growth less than 10%. 3) We look for margin of safety of 30-50% depending upon industry, company and our own confidence. Once we have followed all the above, I think a rate which is 2-3% higher than 10 year government bond should be fine (so around 10%). The logic is one should not invest in stock if one is not certain of earnings more than risk free rate.

Vishal Khandelwal says

Hi Anil, thanks for your inputs! I had intended to mention a range of 10-15% in the final DCF checklist above, like the ranges I mentioned for growth rates and terminal rate. But it just slipped out. Have corrected the same. Regards.

Vivek says

Dear Vishal,

While looking at Colgate’s DCF calculation above….the Present Value figures for the first five years are same.

Is it ok…?

As the excel calculation shows different figures for those years.

Thank You

Vishal Khandelwal says

Vivek, the image is just for instructional purpose. Just go by the excel calculations.

Vivek says

Thanks Vishal..

sudhir says

Very informative and instructional as well, so one can go step by step. Thanks.

Could you put a excel sheet (like the one you have) or formula for terminal value as well. For example how did you arrive at the value of 35,94,28——. I want to see the calculation. I remember doing it in some case myself but need help here to refresh.

Vishal Khandelwal says

Thanks Sudhir! Box E-28 shows the calculation of terminal value. Regards.

sanjeevbhatia says

Sudhir, we see only the formula results in respective cells. many a times, it so happens that we want to see the formula instead. There is a great shortcut in excel for this.

For eg. to see the terminal value calculation, simple select cell E28, and press CTRL plus ` (i.e. ctrl + the key just prior to 1, or the one just above the left tab key). You will come to see the formula inserted in a cell instead of formula result, not for one cell but for whole worksheet. What’s more, you simply toggle it on and off. This is very handy when you want to alternate between a cell formula and its result.

Hope that Helps. 🙂

Sanjeev Bhatia

sudhir says

thank you.

sudhir says

thank you once again. it is a very helpful input.

karthik says

thank u Bhatia Ji…

Vijay says

Nice article Vishal! (as usual 🙂 )

I really love the reverse DCF part . As Charles Munger keeps saying, “Invert, always invert”

Vishal Khandelwal says

Thanks Vijay!

sanjeevbhatia says

Good Nicely detailed article, Vishal. Although I got the hang of it in Delhi Workshop, but it was great to refresh it here again.

My only confusion point is :’ Since we are being conservative everywhere, the FCF growth rate, the discount rate and the terminal growth rate, and put MoS on top of it, Will it not lead to a IV which can never be attained unless there is sudden deep panic situation, and in that case also, the window of opportunity might not exist for time long enough for one to react? Do we tweak the MoS on case to case basis for situations like this?

For reverse DCF, one can use the Goal Seek feature of Excel, a very powerful tool.

Thanks

Vishal Khandelwal says

Yes Sanjeev. But that’s why Buffett believes that true value investors always enjoy bear markets. 🙂

Also, DCF is just one of the IV methods. Other methods will throw up different numbers, and then we need to take a fair value range. That will I believe give you a realistic picture, even if DCF value is a bit conservative.

Yes, you can alter the MoS to have it between 30-50%. Regards.

sudhir says

waiting for the next stock talk where all 4 methods are applied 🙂

Vishal Khandelwal says

Sudhir, it’s coming soon. 🙂

Venkatesh says

can i know the other three methods name as i am beginner and video link if any or article.

Saurav Jalan says

Thanks Vishal for sharing this knowledge of DCF explained beautifully with a lot of simplicity. I had one query in my mind. If we assume discount rate on the basis of the opportunity cost of capital, then shouldn’t we assume discount rate by the logic of long-term returns of the index( provided the index has a decent balance of both the risky and safe companies) .

Any effort of investing in individual securities would be futile if one is not able to beat the index in the long-run.

Thanks and waiting for your views on the same.

Regards,

Saurav Jalan

Vishal Khandelwal says

Yes Saurav. And in this case, the opportunity cost (15%) is also very close to the long term return from the index. 🙂

sudhir says

Saurav the way I would look at it is, why am I investing in shares and realistically what kind of returns can I generate over say a 5 to 10 year period.

Now you may say as high a return as possible but that is why I asked realistically how much. There are a miniscule few who have been able to maintain consistent high returns. Infact the media only potrays a few number of winners (not just in investing but in all fields) and ofcourse never mentions a large no. of others who made lesser or who lost money. So one bias that gets into our minds is that if he can, may be even I can. Surely that is a great way to look at things but put a pinch of salt called realism should put into the dish as well.

One way to look at it could be if FD is giving a post tax return of say 6 to 7% then if I can get twice that from stocks I should be happy. Therefore if I can generate 12 to 14% I should be satisfied. But mind you even this is a hell of a task.

The Sensex CAGR is around 14% or so since inception.

sudhir says

One disconnect. For example in the case you have cited Colgate, given that the share is at say 1200 and even in the past would typically have been expensive (high FCF, MNC, Moat etc) how many instances say in the last 10 years would you find where its value touches the intrinsic value with a certain MOS. I would think we should exclude the 2008 and 2009 period of turmoil.

What I am trying to say is how long do you wait and wait and what about the opportunity cost.

I am sure the answers will be “patience is the key”.

Vishal Khandelwal says

In fact, Sudhir, the total FCF Colgate has earned in the past 3 years has been 145% of the total FCF it earned in the 6 years prior to this period. So the last 3 years have in fact been the best ones for the company. I have not done a comprehensive analysis on the company and thus not sure whether the stock was available at or near its IV sometime in the past. There are many such stocks out there where all valuation metrics will suggest “don’t buy”, while the prices will continue to rise. Sadly there’s no way to take a decision here except the gut feel (but only after seeing how far or close the stock price is with respect to the IV).

sudhir says

Yes gut is one. The other factors like “story of the year” or “trend” or “liquidity” or “consumption story” are other significant factors.

That is why intrinsic value is a good way to start (and always keep it in mind since stocks come down touch such intrinsic values and bounce back) but it can keep you on the sidelines for long times from gems.

Like you yourself mentioned you just kept eyeing Asian paints for long and regret.

karthik says

Well.. Mee to in same boat.. Stocks such as colgate/gsk/pfizer/godrej…. am unable to work out

priyaranjan says

Different industries & within the same industry different companies have different growth trajectories so will it be right to take the same growth rate for all of them?. As far as annual growth rate is to be taken as the discount rate I think the cost of capital is another important consideration counting the capital structure .Sorry vishal ji ,but I have not studied this post & just made a snap study of it.

Vishal Khandelwal says

Hi Priyaranjan, well that is definitely an issue and that’s why there must be a range of growth estimates. Also, in the long term, most companies converge to an economy’s growth rate and that’s why I am comfortable using a 8-10% rate for most companies. With respect to the discount rate, I believe the opportunity cost of capital plays a more relevant role than the cost decided by a company’s capital structure. Regards.

Avadhut says

Hi Vishal,

That’s really a good explanation of DCF.

Yes, I’ve seen complex financial models and DCF valuations where the analyst himself gets lost and doesn’t understand how to get out of it 🙂

Anyways, I checked the excel sheet, I want to know why you’ve multiplied two values by 10, that’s Cell E5 and E12 .

Can you please explain this ‘Net Debt Level’ figure = (-2850)*10^6?

Regards,

Avadhut

Vishal Khandelwal says

Thanks Avadhut! That’s to convert “Rs million” figure into an absolute number. 🙂

Net debt = Debt – Cash. A negative figure implies that Cash > Debt.

Avadhut says

You mean –you want all figures in millions, so did this?

Vishal Khandelwal says

I wanted all absolute numbers. The figures in cells E5 and E12 were in millions to converted them to absolute nos. by multiplying them with 10^6.

Aravind says

Hi Vishal,

Is the net debt level in the excel sheet calculated in rupees while the other parameters are calculated in millions?

Thanks.

Vishal Khandelwal says

Hi Aravind, all figures in the excel are absolute amounts.

Jana says

Hi Vishal,

Half of Total PV of Cash Flows is being contributed by Terminal Value.

2 things should happen for this to work.

1. The company must exist and still generate the FCF it produced at year 10.

2. The growth rate assumption should hold good.

Both 1 and 2 are huge assumptions. Hence I prefer keeping the growth rate and Terminal value as 0 to be zero. What do you think about this?

Regards,

Jana

Vishal Khandelwal says

Jana, a lower growth numbers is always better…and provides a margin of safety. A stock looking attractive with zero growth can be a good bet (assuming the business ins’t dying).

Avadhut says

Hi Vishal,

I also wanted to know if company has ‘Standalone’ and ‘Consolidated’ financials, like Colgate, which figures to consider for DCF?

Regards,

Avadhut

Vishal Khandelwal says

Always use “Consolidated”, as it gives a better picture.

Avadhut says

Hi Vishal,

Thanks for clearing my doubt.

In the attached screenshot, the purchase of fixed assets figure is 102,22.30. But I couldn’t find this figure in the fixed assets schedule. Can you please tell me where the figure came from?

Regards,

Avadhut

Avadhut says

Hi Vishal,

Can you please explain how did you arrive at this 3-year avg.FCF figure, that’s 3090 million?

I calculated this figure, but it’s coming to 3264 million. Also, the figure – “Net Cash from Operating Activities” for the year 2010-11 is quoted differently in 2012 and 2011 annual report.

How to go about it?

Regards,

Avadhut

Avadhut says

The same case with “Net Debt Level”

In 2012 annual report, Long term borrowings is “Nil” and “Cash and Bank Balances” figure is 3098.054 million or 309.8054 crores. How did you arrive at the Net Debt Level figure at 2850 million?

Regards,

Avadhut

Shankar says

Hi Avadhut,

The borrowing includes, All the non-current liabilities (long term borrowings, long term liabilities, long term provisions etc), all these together make a figure of 30,82.24. And you know about the cash, subtract it from the above figure(30,82.24 – 309,80.54 ) and you will arrive at figure of -27898.3, which is a net debt..

Any doubts let me know..

Regards,

Shankar

Avadhut says

Hey Shankar,

Thanks a lot for taking time to explain this.:)

rojo says

Thank you for a great article. I think you did a very good job explaining the DCF and advocating a conservative approach. Thanks for the great link also!

I have some questions.

First with regard to the terminal value. Comparing how you arrive at a terminal value vs M. Pabrai and B.Greenwald, there seems to be some slight differences.

Greenwalds way: Projected cash flow for year 11 times a multiple. This multiple is equal 1 divided by the difference between the cost of capital and the perpetual growth rate -> 1/(cost of capital less growth) And then discounting it.

-His way of arriving at the terminal value is equal to yours when we are using Year 10 FCF. I’m not sure why he uses year 11 projected FCF. Maybe I am misunderstanding his writing. It’s on page 32 in Value Investing From Graham to Buffett and beyond. I’ve read elsewhere on the web that you should indeed use the last year (year 10 in the case), so I’m a little puzzled as to why he uses year 11.

Pabrai advocates a rather more simple approach. He simply says to use a multiple, i.e. 10, and then multiple it by FCF for the last year (year 10).

My other question was regarding Net debt level. Pabrai (The Dhando Investor) uses the term Excess Cash. Is your Net debt level the equivalent to his excess cash? And if so could you please elaborate as to why current liabilities are not considered and perhaps explain the logic behind the term “net debt level”?

Lastly I would love to hear more about how you arrive at the FCF. What to look for in a Cash Flow Statement. For example, should we not add back sale of fixed assets?

Guruprasad says

Hii Vishal/all,

Could anyone please let me know , where did we get the 1st year Cash flow of Rs 3,39,90,00,000 , I mean I was referring to Cash flow sheet on Moneycontrol site and could not find the above value and was not sure which one to refer , is it Net (decrease)/increase In Cash and Cash Equivalents ? Please advice.

Also, assuming we have calculated the intrinsic values of specific stocks , the question is..how long do we have to wait , what is the possibility that the market will allow us to buy the stock at the intrinsic value or close to it.

Regards,

Vishal Khandelwal says

Dear Mr. Guruprasad, the FCF used is the 3-years average FCF for the company. As for the second point, well if you have done your homework for the stock correctly, you can wait and you will be rewarded. This mostly happens. 🙂

karthik says

Vishal.. Thanks for the explanation… I tried usin the exce lfor calculating the Clariant chemicals DCF.

The Net cash from operating activity is 1377 Lakhs whereas purchase of fixed assets is 4843 lakhs..

Now FCF becomes negative.. How should we tackle this??

Sunny says

Free cash flow = Net cash from operations – Cash spent in asset purchase + cash inflow in asset sale

Pls also check how much cash inflow occurred in asset sale, not just the outflow in asset purchase…

Hope that clarifies

karthik says

Thanks a Lot Sunny…..

Neha says

Hi Vishal,

Could you please explain the reason for using last 3 years average FCF as the starting point, why not last 5 years or 10 years?

Rudra says

Hi Vishal,

Superb article. Really wonderful how you have broken down a complex subject in such simpler steps.

two things, firstly the measure of scenario analysis (varying FCF growth, terminal growth vis-a-vis discount rate). The range of values is always better than an end value. enhances price visibility with changing expectation both on upside and downside.

secondly the assurance of cash flows in stable business. FMCG like Nestle, Colgate, HUL will command a P/E premium due to the stability of earnings, the strong brand moat and market leadership position. How do you feel we assign for this in our valuation model, by increasing the FCF percentage or reducing the hurdle rate or margin of safety ?

shans281 says

Hi Vishal,

Using the example in your post, I was calculating Terminal Cash Flow as (Terminal Cash Flow X (1 + Terminal Growth Rate)) / (Discount Rate – Terminal Growth Rate).

However this gives me a ridiculously stupid figure !

Can you show me the way please 🙂 ?

Regards,

Shantanu

shans281 says

Please ignore my earlier post. I have been able to sort it out.

Krish says

Sunny, you should not add cash inflow from asset sale for FCF calculation.

Sunny says

Hi Krish

Can you pls explain the reason why cash inflow from asset sale should not be added back to Free Cash Inflow? Is not FCF is the “cash remaining” after excluding “net cash invested” in the business? If a business retires old equipment and spends some money to buy new equipment, would you not count cash inflow from sale of old equipment, which is essentially reducing the “net outflow” in equipment replacement?

Regards

Sunny

Krish says

Sunny, Lets say a company which bought a piece of land 10 years ago for 1 crore, sells the land for 10 crores.

This year the company took a heavy loss and its CFO is -2 crores with another 2 crores spent on capital expenditures.

Now if add the cash inflow from asset sale we get FCF as -2 – 2 + 10 = 6 crores. If you just look at this FCF its not going to raise any alarm bells but we take FCF as CFO – Capex we get -2 -2 = -4 crores which immediately raises an alarm in your mind and you start asking further questions about the company.

Will the company regularly sell such assets in the future, obviously not but if we add it in our calculation it hides the real picture, so we ignore inflow from asset sale. We should focus only on the core operations of the company, other income should be given a very low or zero priority.

Sunny says

Hi Krish

Of course, I agree. I forgot to mention that precursor is that CFO should be positive. Any “net inflow” from investing doesn’t count…only I’m reducing net outflow in investing, provided CFO is positive…

But good point, I’ll modify the XLS I use with this condition 🙂 Thanks

Sridhar says

Hi Vishal,

Thanks for sharing these valuable insights on DCF. I found it interesting though I didnt read this page fully….ill come back once again.

I particularly liked the idea of discounting the growth rate of cash flows instead of hiking the discount rate.

This is a more sensible way of calculating, which even finance text books seem to ignore.

At the end of the day I feel its all about understanding the business dynamics such as revenue model, potential cash flows, risks involved, etc and coming up with a realistic cash flow projections and moderate growth rate assumptions.

Whats the point in showing a high growth and discounting at a higher rate?

Once the cash flow forecast is reasonably okay, then the NPV and IRR using a 15% discount rate (or slightly varying as per the industry/business) would be good enough.

This is a more realistic and simple idea which I liked and I feel analysts should adopt the same.

Vishal Khandelwal says

Thanks Sridhar! Yes you said it right – the cash flow assumptions need to be reasonable and than one can use a 15% discount rate with some variation for business quality.

krish says

Hi Vishal,

I was just going through the excel and I could not calculate the net debt value ( 2,85,00,00,000) from the data given in the 2012 annual report.

Net debt = Long term borrowing ( 30,82.24 ) – Cash ( 309,80.54 ) = -27,898.3

What am I missing here?

Vishal Khandelwal says

Yes Krish, the correct number is -27898.3 and not 28500. Thanks!

Juan Ochoa says

Dear Vishal: Thank you for sharing your knowledge.

Shouldn’t you add or subtract Net Debt from the PV of the CFlows. In this example as Net Debt is negative (Cash surplus) shouldn’t you add it?

I don’t see this done in your example (Perhaps my error).

Thank you!

Nishanth says

A realy good explanation,Vishal.Gives people like me a good point to start off with DCF calculations.

K.J.Vijayakumar says

Hi,

This article is really a good one to learn and apply DCF method. I tried to apply this technique for Bosch Ltd., which has a negative Free Cash flow 2 years back.

When I take last 3 years Free cash flow to calculate base FCF, how should I consider this negative Free cash flow ? Just an average of 3 years ?

Apart from that, I would consdier a 10% discount rate or max 12%, because this 10% assumtion is based on the fixed deposit rate which is closely I would get after a year.

Which is what I should pay “now”. May I know your comment on this assumption ?

Lastly, what are the pros and cons of DCF. I know the important point that It can give me is 100% wrong results :-). Apart from that any other points or limitations?

Thanks

Vijay

jeet says

Hi Vishal,as per above calculation using same FCF,growth and terminal percentages the intrinsic value I calculated for Haldyn glass is 49 which shows that the stock is highly undervalued at cmp of Rs. 18.Please let me know if the value I got is correct and the assumption is true as well.Thanks.

Rajesh Kanakia says

hi difficult to understand as figures do not match. do you have a video of the same or please make one. thanx

Cherin Lapashiya says

Dear @Vishal There are a few issues i encountered while working with FCF DCF, which are as follows:

1. the FCF gives vague results while calculating Financial Sector (including banks, NBFC, insurance companies etc). Even for Banks like HDFC, Axis, Kotak the FCF is Negative. How do we measure Financial Sector since FCF is handicaped in this case?

2. Companies State one Value in their Current Year Reports for previous year (restating the previous data), while they state different value in the Last year’s Annual Reports. (Eg: Net Operating Cash Flows for ONGC 2012 Annual Report, and the 2013 Annual Report). and such Restatements are highly common. How do we deal with this issue? Which data should we use and why?

3. FCF for Growing or Currently Distressed Companies is also negative. How do we use FCF in that case, (other than the issue with Negative FCF for Finance Sector)?

Tushar says

Hi,

How does one evaluate companies that have negative cash flow using the DCF method. The negative cash flow may be because it is making consistent losses in which case its a no brainer. But if the negative cash flow is due to large outflows on account investing, how does one value the stock.

–

Rajat Gupta says

Hi Vishal, I am facing difficulties wrt getting data. None of the websites are providing detailed Cash flow statement. From where do I get data reg how much the company spent on purchasing fixed assets in a year & previous years. Same issues with detailed P&L statement. Any links from where can I get the same?

Vishal Khandelwal says

Rajat, consider reading annual reports.

Raman says

Hi Vishal,

Really found this article on using DCF very helpful. In particular, the “sanity check” using the reverse DCF method, your 2 step growth rate, and the article from James Montier. I’m now implementing this in my stock analysis.

Love the website and look forward to your articles. Keep up the good work (from a reader in the UK).

Vishal Khandelwal says

Great to know that, Raman. Thanks!

Devansh Nigotia says

I have few queries:-

(1)How can I get estimates of Future capital allocation(i.e Investing in P&M) activities for 5-10 years cash flows down the line, As it will affect my free cash flow. Can you share about how to calculated inputs ?

Piotr says

I just checked Colgate outstanding shares in 2012 and the number is 960 Mil. Where did you take the 136. Mil from ? It makes a big difference when it comes to the intrinsic value. Thank you.

Raghav says

Hi Vishal!

You have a fabulou sway of explaining things. I have been struggling with DCF for past couple of months – your simple 2 stage calculation is all I needed to understand & apply the concept. I saw Prof. Damodaran’s videos on youtube on Valuation class & understood nothing basically. Doesn’t help that I have zero finance background.

Pls accept my gratitude & thank you for the simple, lucid way of explaining concepts!

Cheers

Raghav

Shubham Sharma says

‘All experts are wrong, some are useful’ like you Vishal! You really explained the most important value investing lesson in such a simple way.

I was actually reading ‘The Dhandho Investor’ some days ago, and Mohnish mentioned in his book a similar way of doing DCFs. He said “if it requires me to fire up excel, it is a big red flag that strongly suggests I ought to take a pass”, and said he preferred a back-of-the-napkin calculation.

So, when I read that it left me really wondering. Is it really so simple?

I’ve learned that it’s not so simple, because that two minute DCF calculation comes from a thorough research about the company, which paints up the simple intrinsic value picture.

This article of yours has actually solved my confusion of following simple DCF process, on the back of thorough research.

Thanks a lot Vishal 🙂

Your lifelong student,

Shubham