NPV Net Present Value What does it mean with examples

The Net Present Value (NPV)

We have already determined the future free cash flow for the next decade as well as the terminal value (future free cash flows of ARBL until perpetuity). Now, we need to determine their current value. Remember this is done through a present value calculation. Subsequently, we will add these values together to determine the net present value (NPV) of ARBL.

Taking into account a 9% discount rate, we will move forward.

In two years’ time, ARBL is forecast to receive Rs.195.29 Crs; discounted at 9%, this amounts to a present value.

= 195.29 / (1+9%)^2

= Rs.164.37 Crs

This is what the present value of the future cash flows looks like.

(Add table)

In order to figure the net present value for the terminal value, we should simply discount it by the discount rate.

= 9731.25 / (1+9%)^10

= Rs.4110.69 Crs

Therefore, the sum of the present values is equal to the NPV of future cash flows and the PV of the terminal value.

= 1968.14 + 4110.69

= Rs.6078.83 Crs

I anticipate ARBL will generate a free cash flow of Rs.6078.83 Crs in the present and beyond, all of which will be owned by its shareholders.

– The Share Price

We are now at the conclusion of our DCF analysis: we must compute ARBL’s stock price based on its upcoming free cash flow.

We can now determine the per-share price of ARBL by dividing the estimated free cash flow with the outstanding shares.

Before beginning, we must compute ‘Net Debt’ from its balance sheet. This involves subtracting current year cash & cash balance from total debt for the same period.

Net Debt = Current Year Total Debt – Cash & Cash Balance.

For ARBL, this is reflected on the FY14 Balance sheet.

Net Debt  = 75.94 – 294.5

= (Rs.218.6 Crs)

A negative figure implies the firm has a greater quantity of cash than debt. This, in turn, must be taken into account when calculating the total present value of free cash flows.

= Rs.6078.83 Crs – (Rs. 218.6 Crs)

= Rs.6297.43 Crs

Divide the above figure by the quantity of shares, and you’ll get the company’s share price, which is also known as the intrinsic value of the company.

Share Price = Total Present Value of Free Cash flow / Total Number of shares.

The ARBL’s annual report makes it clear that the total number of outstanding shares is 17.081 Crs, thus giving each share an intrinsic value.

= Rs.6297.43 Crs / 17.081 Crs

~ Rs.368 per share!

The results of the DCF Model can be seen in its final output.

• Modelling Error & the intrinsic value band

The DCF model is scientific, yet its success relies on making assumptions – an art form developed through experience. We must assume that some of our intrinsic value calculations may be inaccurate and plan accordingly for modelling errors.

A leeway for the modelling error enables us to be more accommodating with computing the per-share value. I favour including a 10% upper limit and a 10% lower limit when assessing what I think is the stock’s intrinsic value.

Using that in our computations –

Lower intrinsic value = 368 * (1- 10%) = Rs. 331

Upper intrinsic value = Rs.405

Therefore, the intrinsic value band lies between Rs.331 and Rs.405, rather than settling on Rs.368 as its fair value.

Considering the value of the stock, we assess its current market price and draw a conclusion.

1. If the stock price falls beneath its lower intrinsic value band, we would deem it to be undervalued and recommend considering buying.
2. The stock’s price being within the intrinsic value band suggests it is fairly valued. Therefore, there is no need to invest any more in the stock, although one may choose to keep their current positions.
3. If the stock is trading above its higher intrinsic value, it is deemed to be overvalued. An investor may take profits at these levels, remain in position, or avoid investing altogether.

To ascertain Amara Raja Batteries Limited’s stock price as of today (2nd Dec 2014), we can refer to a snapshot on the NSE’s website. Such instructions should be duly followed for the best results.

The stock is priced at 726.70 per share, which is way above the maximum intrinsic value band. Investing at these prices basically means you’ll be acquiring the stock with excessive valuations.

• Spotting buying opportunities

Long term investing and activities associated with it are akin to a slow-moving train on the tracks. Active trading, on the contrary, is like a bullet train that rushes by. When a long-term value opportunity is created, it usually sticks around for a bit before eventually disappearing. Consider, for example, Amara Raja Batteries Limited, which is currently trading at an above-average rate compared to its intrinsic value band. A year ago; however, it was quite contrasting as the intrinsic value band of ARBL was Rs. 331 and Rs.405 derived from FY 2013- 2014 results.

ARBL’s chart has been provided here. This provides information about ARBL.

The blue highlight clearly demonstrates that the stock had been trading within the band for almost 5 months – it would have made a great purchase at any point during that year! Then, all you had to do was remain in the investment and watch your returns increase!

It is said that bear markets generate value. Indeed, during the entirety of 2013, the market was bearish, which in turn provided investors with numerous opportunities to purchase high-quality stocks at a low price.