Valuations

Discounted Cash Flow Valuation

• “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.”

• When future cash flows are reasonably predictable and an

appropriate discount rate can be chosen, DCF analysis is one of the
most accurate and precise methods of valuation.
 Discounted Cash Flow Valuation
• The faster the earnings or cash flow of a business is growing, the greater
that business’s present value. Yet several difficulties confront growth-
oriented investors.

1.Such investors frequently demonstrate higher confidence in their ability to

predict the future than is warranted.
2.For fast-growing businesses even small differences in one’s estimate of annual
growth rates can have a tremendous impact on valuation.’ Moreover, with so
many investors attempting to buy stock in growth companies, the prices of the
consensus choices may reach levels unsupported by fundamentals.
• As Warren Buffett has said…
• For the investor, a too-high purchase price for the stock of an excellent
company can undo the effects of a subsequent decade of favorable business
developments.
Discounted Cash Flow Valuation
• Using DCF
1.Estimates of growth in future free cash flows (FCF): Growth in FCF over
say the next 10 years, using last 3 years average FCF (free cash flows) as
the starting point.
2.Terminal growth rate: Rate of growth in FCF after the 10th year and till
infinity.
3.Discount rate: Rate at which the future cash flows must be discounted to
bring them to present value.
Discounted Cash Flow Valuation
1.How do I predict future FCF?
• Trying to find a perfect answer to the question “What growth rate to
assume?” is like trying to find a “perfect couple”. None exist!
• That’s why I now don’t try to be accurate with my FCF growth estimates. I
just try to be reasonable and use common sense.
• I rarely go above 20% annual growth rate for the first five years, and 10%
for the next five.
Sample Cash Flow Statement (from Annual Report)

MINUS
Discounted Cash Flow Valuation
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.
• 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).
Discounted Cash Flow Valuation
2.How much discount rate do I assume?
• The higher the discount rate you assume, the lower you must pay for the stock
as of now.
• 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, Colgate, Hero Motocorp),
earning around 10-12% annual return over the long term is a good
expectation. For valuing such businesses, take 10-12% as the discount rate.
Discounted Cash Flow Valuation
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%.
Relative Valuation Methods
• These are collectively called “Relative Valuation” techniques, and
consist of –
▪ Price/ Earnings (P/E)
▪ Price/ Book Value (P/BV)
▪ Price/Sales Ratio (P/S)

• The reason these are called “relative” valuation techniques is because

the value of an asset here is derived from the pricing of comparable
or relative assets, standardized using a common variable such as
earnings (P/E), cash flows (P/CF), book value (P/BV) or sales (P/S).
Relative Valuation Methods

• An advantage is that relative valuations provide us information as to

how the market is currently valuing stocks at several levels (aggregate
market, alternative industries, individual stock within industries).
• The core idea of relative valuations is to convert the values of
companies sharing similar attributes to comparable multiples and
then seeing how those stocks stand in relation to their peers.
Relative Valuation Methods

1.Price to Earnings (P/E)

• The P/E ratio of a stock is a simple tool for measuring the markets’
temperature. It is calculated by dividing a stock’s price by the
company’s earnings per share or EPS.
• P/E Ratio = Price per share / Annual earnings per share
Relative Valuation Methods
➢How to value stocks using P/E
• Here is how you can use P/E as a technique to roughly calculate stock
valuations –
✓In an industry, identify 5 stocks which are similar to the stock you want to
evaluate.
✓Assuming the average P/E of these five stocks is (14+18+24+21+20)/5=19.4
✓The stock you are evaluating has an EPS of Rs 2.5
✓The intrinsic value you calculate using the P/E would be = P = P/E x EPS =
19.4 x 2.5 = Rs 48.5.
✓Avoid including stocks with negative P/E ratios, which would be due to the
companies having a negative EPS.
✓If the business you are studying is in a better situation than its peers on the
industry average (like in terms of profitability, management quality etc.),
give it some premium to the average P/E.
Relative Valuation Methods

➢How to value stocks using P/E

• Let us understand this using the example of the Indian IT companies.
• The average approximate P/E ratios of the leading companies from the
sector over the last three years are –
• TCS – 34x
• Infosys – 29x
• Wipro – 25x
• Tech Mahindra – 22x
• HCL Tech – 22x
• The average P/E thus stands at 26x.
Relative Valuation Methods
➢How to value stocks using P/E
• Now, if you were to value Infosys, and predict its target price (like analysts
do) two years from now, all you need to do is predict Infosys’s EPS two
years hence, and multiply that by the average P/E of 126x plus some
premium given the company’s standing in the IT industry.
• So, if you believe that Infosys deserves a 29x P/E, you multiply its two-year
forward estimated EPS with 29x and the result is your target price for the
stock.
• Two key factors that determine whether a stock’s P/E is high or low are:
1.Company’s growth rate – P/E of a stock depends on how fast a company
has grown in the past and whether the growth rate is expected to increase,
or at least sustain, in the future. A company growing its earnings at, say, 5%
but commanding a 20 times P/E is definitely expensive.
Relative Valuation Methods

➢How to value stocks using P/E

• Two key factors that determine whether a stock’s P/E is high or low
are:
2.Industry dynamics – P/E ratios also depend on the industry. For
instance, while it is normal for stocks from high growth industries like
IT command P/E ratios of 25-35 times, a utility company (from the
power industry) that grows its earnings at just around 5-6% per year,
will be expensive at 15 times P/E.
Relative Valuation Methods
2.Price to Sales (P/S)
• The price to sales ratio (P/S) compares the stock’s prices to the companies’
sales per share.
• Price to sales or P/S = Price per share divided by Sales per share
• As with the P/E multiple, other things remaining equal, stocks that trade at
a low P/S multiples are viewed as cheap relative to stocks that trade at high
P/S multiples. Unless otherwise stated, P/S is based on the trailing twelve
months sales, although it is always good to examine it on long-term
averages.
• The good thing about the P/S multiple is that, unlike earnings, sales are not
subject to much account manipulation. Although companies can still play
around with sales, the manipulation is much harder to do and much easier
to check. Also, sales are less volatile then earnings over a period of time,
and thus are a relatively more stable metric of value.
 Relative Valuation Methods
2.Price to Sales (P/S)
• In essence, very rupee of sales is worth a lot more in a profitable
company than it is in a less profitable one. The P/S does not capture
this difference. This relative valuation metric is thus useful only to
compare stocks within the same industry and with similar profitability,
or when looking at the same company over a period of time.
• A rupee of sales at a highly profitable firm is therefore worth more
than a rupee of sales for a company with a narrower profit margin.
Thus, the P/S ratio is generally useful only when comparing firms
within an industry or industries with similar profitability levels, or
when looking at a single firm over time.
 Relative Valuation Methods
3.Price to Book Value (P/BV)
• Book value of a company is simply its net worth or equity. Book value per
share is the net worth divided by the number of shares outstanding.
• Price to book value is…..
• Price to book value (P/BV) = Price per share divided by Book value per share
• Book value represents what investors have put into a business, including the
company’s undistributed earnings (part of profits that is not paid out as
dividends).
• It is assumed that if the company were to liquidate (close down its business
and sell its assets), it would receive in cash the value which is at least equal to
its book value – the value at which its tangible assets are carried on the
books.
 Relative Valuation Methods
3.Price to Book Value (P/BV)
• The price to book value (P/BV) measures how much are the markets are
willing to pay for the measured accounting value of a company’s assets.
• There are cases like the software industry, whose biggest assets are its
human resources. Since these resources are not shown in the balance
sheet, such companies trade at high P/BV that does not necessarily make
them expensive.
• Companies with high/low return on capital (return on equity) generally
trade at high/low P/BV ratios.
• As such, you can look at the mismatch between a company’s return on
equity and its P/BV ratio to identify – stocks with low P/BV ratios and high
return on equity can be considered undervalued, while stocks with high
P/BV and low return on equity can be considered overvalued.
Margin of Safety
Margin of Safety
• “No matter how wonderful [a business] is, it’s not worth an infinite price. We
have to have a price that makes sense and gives a margin of safety considering
the normal vicissitudes of life.”

• ~ Charlie Munger
• Buffett said…
• You also have to have the knowledge to enable you to make a very general estimate
about the value of the underlying businesses. But you do not cut it close. That is what
Ben Graham meant by having a margin of safety. You don’t try and buy businesses worth
$83 million for $80 million. You leave yourself an enormous margin. When you build a
bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks
across it. And that same principle works in investing.
Margin of Safety
Margin of Safety
• 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.
Margin of Safety
• Coming again to the question of what is an adequate margin of safety,
the answer varies from one investor to the next. But, as Klarman
writes, it chiefly depends on –

• 1. How much bad luck are you willing and able to tolerate?

• 2. How much volatility in business values can you absorb?

• 3. What is the tolerance for error?

Margin of Safety
• Talking about losses, assume that you buy a stock at Rs 100 when its
intrinsic value is Rs 100. If the stock crashes to Rs 20 within a year
after you buy it, it would have to rise by five times (or 400%) to just
reach its original price, or match the intrinsic value of the business.
• But if you had bought the stock at say Rs 60, and it crashes to Rs 20, it
needs to rise just three times to go back to your original buying price.
While even a three times rise will be like too much for the asking, you
will still be in a better position than what you had been had you
bought the stock for Rs 100.
• So if you think you cannot afford to lose much from your stocks, it
always pays to have a good margin of safety, say around 30-40%. This
means that you must buy Rs 100 stock for not more than Rs 60-70.