Discounted Cash Flow technique The Key to Evaluating Share Prices and Maximizing Investment Returns

In the preceding chapter, we studied stage 1 and stage 2 of equity research. We looked at comprehending the business in step one and analysing the company’s financial performance in the second. One ought to proceed to stage 3 only after being confident with the results from both sections. Here, we summarise stock price valuation.

An investment can really pay off if you purchase a good business at a great price. Even if the venture is only mediocre, being able to get it at an excellent rate makes it worthwhile. This highlights how important the price point is when making investments.

The upcoming two chapters seek to make you aware of “the price”. Estimating a stock’s price can be calculated through the utilisation of a valuation method. This helps us calculate the ‘intrinsic value’ of the business. To determine this, we employ the Discounted Cash Flow (DCF) technique. The intrinsic value, according to DCF is judging the ‘assumed stock rate’ with consideration for its future cash flows.

The DCF model is composed of multiple interrelated ideas. In this chapter, we will begin by getting to grips with the core concept of DCF: “The Net Present Value (NPV)”. Afterwards, we will move on to grasping the remaining ideas that form the foundation of DCF before learning how they come together in total.

• The future cash flow

The DCF model revolves around the concept of future cash flow. We can illustrate this by looking at a basic example.

Vishal, a pizza vendor known for the best pizzas in town, has invented an automatic pizza maker. All it takes is to pour the necessary ingredients into the slots, and after five minutes, out comes a fresh pizza. With this machine, he can expect an annual revenue of Rs. 500,000, and it has a lifespan of 10 years. His passion for baking has definitely paid off!

George is so taken with Vishal’s pizza machine that he offers to purchase it from him.

What is the smallest amount George should pay Vishal to purchase this device? To answer that, we must consider how beneficial the machine will be for him financially. Assuming he buys it in 2014, over the next decade, it will generate Rs.500,000/- per year.

George has an optimistic outlook on his financial future. He expects a healthy cash flow in the foreseeable future and is preparing accordingly.

I was expecting that you could note that I have assumed the machine will begin to produce money from 2015, for the sake of ease.

It is obvious that George will bring in Rs.50,00,000/- (10 x 500,000) during the next decade, and the machine will be valueless afterwards. It is clear that this machine should not be priced higher than Rs.50,00,000/-. Does it really make sense to pay a higher amount for something that has a limited return?

Vishal requests George to make a payment of “Rs. X” for the machine. George has two options – either spend Rs. X and buy the machine, or invest in a fixed deposit plan with an 8.5% interest rate. In this case, George picks the former, coming with its own expense: he forgoes the chance to earn risk-free interest at 8.5%. This is known as an opportunity cost.  

We have uncovered three vital facts in our mission to determine the cost of an automatic pizza maker.

1. The pizza maker will generate Rs.50,00,000 in cash flow over the course of the next decade.
2. Given the known cash flow, it follows that the price should be lower than this sum.
3. The opportunity cost of investing in a pizza machine is forgoing the chance to gain 8.5% interest.

Taking these three key points into account, let’s press forward. We should focus on the cash flow; George will be earning 500,000 rupees annually from his machine for the next decade. It is clear that in 2014 George is anticipating what lies ahead.

1. What is the current worth of the Rs.500,000/- that he acquired in 2016?
2. What is the present-day value of the Rs.500,000/- he received in 2018?
3. What is the present value of the Rs.500,000/- he received in 2020?
4. What is the present worth of future cash flows?

The “Time Value of Money” provides the key to these queries. In other words, by determining the worth of each future cash flow generated by the machine in terms of current values, one can come to an accurate price for the item.

We will deviate from the pizza issue in the upcoming section but ultimately return to it.