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We have already covered stage 1 and 2 of equity research in the previous chapter. Stage 1 was about understanding the company, while stage 2 dealt more with the company's financial performance. Only if both stages have been completed, can one move on to stage 3. Stage 3 is about stock price valuation.
A great investment is only considered great if it is a great business that is being bought at a high price. It is possible to purchase a poor business for a wonderful price. This is what demonstrates the importance of "the price" when it comes investing.
'The price" will be explained in the upcoming two chapters. A valuation technique is used to estimate the stock's price. The 'intrinsic' value of a company can be determined by valuation per se. The "The" valuation method is used.Discounted Cash FlowThe "method to calculate the company’s intrinsic value. DCF is the method that evaluates the company's 'perceived stock prices', taking into account all future cash flows.
There are many concepts that make up the DCF model. They all intertwine with each other. Each concept must be understood individually before it can be placed in context with DCF. This chapter will explain the "Net Present Value (NPV)," the central concept of DCF. Next, we will explore the other concepts in DCF before we understand the whole of DCF.
Future cash flow is the core of the DCF model. This will be explained using an illustration which is simple.
Assume Vishal, a pizza vendor that serves the best pizzas around. He is passionate about baking pizzas and has a flair for innovation. He invented an automatic pizza oven that bakes pizzas automatically. He just needs to put the ingredients in the slots and wait for the machine to bake a pizza. He calculates that he can make an annual income of Rs.500,000/year from this machine and that the machine will last for a decade.
George, Vishal's friend, is impressed by the pizza machine. George is so impressed by Vishal's pizza machine that he offers to purchase it from Vishal.
Let me ask you: What price should George pay Vishal for this machine to be purchased? To answer this question, it is necessary to determine how economic this machine will be to George. If he decides to buy this machine now (2014), he will be able to make Rs.500,000/year over the next 10 year.
Here's how George's cash flow for the future looks.
| 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 |
|---|---|---|---|---|---|---|---|---|---|
| 500,000 | 500,000 | 500,000 | 500,000 | 500,000 | 500,000 | 500,000 | 500,000 | 500,000 | 500,000 |
I was hoping that you could make a note. For convenience, I have assumed that the machine will begin generating cash in 2015.
George will surely earn Rs.50,00,000. (or 10 x 500,000) over the next ten years. After that, the machine is worthless. It is obvious that this machine cannot be more expensive than Rs.50,00,000. It is not a smart decision to pay more for an entity than it provides in economic benefits.
Let's say Vishal asks George for Rs. The machine will be credited with X. Assume George has two choices at this point. He can either pay Rs. X to buy the machine. Or, he can invest the Rs-x in a fixed deposit plan that pays 8.5% interest and guarantees his capital. Let's say George decides to purchase the machine over the fixed deposit option. George has forfeited the chance to earn 8.5% risk-free income. This is the 'opportunity price' for buying the machine.
In our search to price an automatic pizza machine, we have so far uncovered three key pieces of information.
Let's keep the three previous points in mind as we move on. Now, we will be focusing on cash flows. For the next ten years, George will make Rs.500,000/- from the machine. Think about it: George, in 2014 is looking to the future.
These questions can be answered by the realms of "The Other."The time value of money". Simply put, if I could calculate the value of all future cash flows from this machine in terms of current value, then that would make it easier to price that machine.
We will move on to the next section and not get into the pizza issue. However, we will return to the topic eventually.
Finance plays a crucial role in determining the time value of money. TMV is used in nearly all financial concepts. The time value of money can be used for everything, including financial derivatives pricing, project financing, and calculation of annuities. The "Time value of money" can be compared to the engine of a car, the "Financial World" being the car.
The idea of the time value money is based on the fact that money changes over time. The value of Rs.100 today may not be Rs.100 two years later. The reverse is true. As of today, Rs.100 in 2 years will be Rs.100. There is always an element of chance when there is time passing. This opportunity requires money to be measured and adjusted.
We need to determine the value of the money we have now and in the future. Then we can move the money today through the future. This is known as the "Future Value (FV)."The money." Similar to the above, we must evaluate the future value of the money we expect to receive in today's terms. Then we need to return the future money to today's terms. This is known as the "Present Value (PV)."The value of money."
Both cases require that the money be adjusted for the opportunity costs because there has been a passing of time. When we need to calculate the future worth of money, this adjustment is known as "Compounding". When we need to calculate the current value of money, it is called "Discounting".
Without going into the math involved (which is actually very simple), I will show you the formula to calculate the FV or PV.
Example 1.What is Rs.5000/- worth in current terms, 2014? Assuming an opportunity cost of 8.5%
This is called Future Value (FV) calculation, which is used to calculate the future value of money we have today.
Future Value = Amount * (1+ chance cost rate) Number years.
= 5000 * (1 + 8.5%) 5
= 7518.3
In other words, Rs.5000 today is comparable to Rs.7518.3 over 5 years, assuming an 8.5% chance cost.
Example 2What is Rs.10,000/- receivable worth after 6 years? Let's assume an 8.5% opportunity cost.
This is evidently the case with Present Value (PV) computation, as we attempt to calculate the future cash receivable value in terms of today's value.
Present Value = Amount/ (1+Discount Rate), Number Of Years
= 10,000 / (1+ 8.5%) 6
= 6129.5
This is equivalent to Rs.6,129.5 after 6 years, assuming an 8.5% discount rate.
Example 3- I would like you to reask with a modification of this question: What is the Rs.7518.3 receivable for 5 years, in today's terms? Given an opportunity cost @ 8.5%
This requires us to calculate our present value. We also know that the answer to example 1 should be Rs.5000/=, as we did the opposite. To verify this, let's calculate the present value.
= 7518.3/ (1 + 8.5%%) 5.
= 5000.0
If you have mastered the concept of time value of money, then we can now return to the pizza problem.
We are still evaluating the cost of the pizza machine. We are confident George will be entitled to a stream cash flow (under the ownership of the pizza machine) in future. This is the cash flow structure
| 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 |
| 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 | 5,00.000 |
This question was already posted, so I'll repost it.What is the value of the cash flow for the future in today's terms and how much?
We can see that the cash flow is evenly distributed over time. Each cash flow (receivable in future) must be calculated by dividing it with its opportunity cost.
Below is a table showing how to calculate the PV for each cash flow while keeping the 8.5% discount rate.
| Year | Cash Flow (INR) | Receivable in (years) | Present Value (INR) |
|---|---|---|---|
| 2015 | 500,000 | 1 | 460,829 |
| 2016 | 500,000 | 2 | 424808 |
| 2017 | 500,000 | 3 | 391481 |
| 2018 | 500,000 | 4 | 360802 |
| 2019 | 500,000 | 5 | 332535 |
| 2020 | 500,000 | 6 | 306485 |
| 2021 | 500,000 | 7 | 282470 |
| 2022 | 500,000 | 8 | 260,335 |
| 2023 | 500,000 | 9 | 239,946 |
| 2024 | 500,000 | 10 | 221151 |
| Total | 50,00,000 | 32,80,842 |
The sum of all future cash flows and their present values is known as "The Sum of All".The Net Present Value (NPV).". In this case, the NPV would be Rs.32,80,842T his means that all future cash flows to the Pizza Machine would have a value of Rs.32,80,842. Vishal will need George in order to buy a pizza maker.32,80,842Or less, but not more. This is the price George should pay to get a pizza maker..
Think about this: What if the pizza maker was replaced by a company? To evaluate the stock price, can we discount future cash flows earned by the company? Yes. In fact, this is what we will do with the "Discounted cash Flow" model.