The discounted cash flow method of valuing a company, though theoretically sound, is filled with assumptions
In the first part of this article which appeared last week, we spoke at length about the price earnings multiple model which is most commonly used by analysts to forecast stock prices. The second most popular model used by analysts is the discounted cash flow model.
Just to recapitulate, we are attempting to explain how analysts arrive at stock price forecasts to reason out why they cannot arrive at an exact number for the target price.
Discounted cash flow: To understand this, investors need to understand the concept of time value of money. To give an example, Rs 100 in hand now is worth more than Rs 100 after 12 months. The reason being, the money in hand can be invested in a fixed deposit of 1 year at 8 per cent and the value of the money in 12 months will be Rs 108. Conversely, the current value of Rs 100 received in 12 months is Rs 93 (if you invest Rs 93 at 8 per cent for 12 months, you will receive Rs 100).
The value of a company is the present value of the stream of cash flows generated for equity holders in the future. The analyst makes an estimate of the cash flow that will be generated by the company in future and discounts the same at a rate called 'cost of equity' to arrive at the current value of the company.
The cost of equity is the return demanded by the investor for investing in that particular stock. This is company-specific as the investor may demand based on the perceived risk in buying a particular stock. To give an example, an investor may perceive there is lesser risk in investing in HLL than buying shares of a technology company.
As a result, the cost of equity will be lower for HLL as compared with a tech company as the risk is directly proportional to rewards and an investor will demand higher return for taking additional risks.
The riskiness of a stock is usually referred to as the 'beta' and is based on the estimate of the performance of the stock in relation to the market. To give an example, on a day when the market goes up 5 per cent, if the stock goes up 10 per cent, the beta of the stock will be 2.
Usually detailed estimates of profit & loss account, balance sheet and cash flow are made for the first 3-5 years. The expected growth rate of the company can be reasonably estimated depending on what stage of growth it is in. The estimated cash flow is discounted back to the present value using the cost of equity.
The next step is to calculate the terminal value i.e. the value of the company once the growth rate has matured. The analyst has to make an estimate as to what will be the growth of the company (after the initial 3-5 years) for the rest of the life of the organisation i.e. next 25-50 years.
Usually the terminal growth rate of the company can be anywhere between 5-15 per cent. However, a small change in the terminal growth rate can make a large impact on the value of the stock.
For the same cost of equity is 13 per cent, the price per share increases substantially -- from Rs 115 to Rs 155 -- for an increase in growth rate from 8 per cent to 12 per cent.
Under current market conditions, when barriers to entry are falling, it is difficult to predict the growth rates 2 years hence. You need a crystal ball to predict the growth after 5-10 years and hence it can at best be only a guesstimate.
The second important factor in the valuation is the cost of equity, i.e. the return demanded by the investors. As stated previously, it is calculated using the risk indicator called 'beta'. Beta is estimated using the historic performance of the stock. A lot of companies have multiple businesses and they enter into new and exit businesses.
As a result, the riskiness changes over time and hence historical estimate of beta using historical performance may not be useful going forward.
Furthermore, dynamics of the industry change which can lead to either an increase or fall in interest in the sector in which the company operates which impact the beta.
Let us assume the historical estimate of beta is 1.30 and the new beta for valuation is estimated at 1.40. For companies with high beta, which is usually the case in tech companies, the small movement in beta will lead to a 1 per cent increase in the cost of equity. For a constant long-term growth of 8 per cent, a change in cost of equity from 13 per cent to 16 per cent, the value of the stock decreases from Rs 115 to Rs 90.
The valuation of company using discounted cash flow, while theoretically sound is filled with assumptions. It would be wrong to make an assumption of just one number and usually scenario analysis is used while making estimates. That is the reason why we can come up with only a range of values for a stock using either discounted cash flow or P/E multiples.
Conclusion: The idea is not to criticise analysts for giving price targets or ask investors to ignore target prices given by analysts, but to point out that retail investors should remember that the value of a company can be estimated to be a range and not an exact number. Investment calls should be taken keeping this in mind.
(The author is a chartered accountant and independent financial analyst)
