Value Investing : Discounted CashFlow Method | Free Cash Flow


Discounted CashFlow Method

DFC method is the most effective method in valuation. Many of the investors use this method to find intrinsic value. The most important thing we use in the DFC method is free cash flow.

Free cash flow – After all operating expenses and capital expenditure the money left in the company is called free cash flow.

A company can manipulate its profit but to manipulate free cash flow is very difficult. We have to calculate the free cash flow by the cash flow statement of the company.

The formula of Free cashflow = operating cashflow – capital expenditures (purchased of a fixed asset)

Cash flow from operations.

So, to understand it clearly, we continue the example of “Info Edge”.In the cash flow statement of Financial Year 2019, we can see –

  • Net cash flow from operations = 275 crores.
  • Purchase of property, plant, and equipment and intangible assets = 26 crores (these are the purchase of fixed assets).
  • Free cashflow = 275 crores – 26 crores = 249 crores
  • The first step in the DFC method you have to calculate the free cash flow of 5 to 7 years of the company.
  • You can easily get an annual report of any company with the help of google.

Last five years free cashflow of Info Edge

YearFree Cash Flow (in Crore)
FY 2019249
FY 2018239
FY 2017197
FY 201645
FY 2015-390

So now, the next step is you have predicted the future cashflow of the company. Predicted future cashflow must be reasonable (risk management). Now the question arises is how to predict the future cash flow of the company.

You can predict the future cash flow of the company by examining these factors:

  1. Company’s business
  2. Growth
  3. Management ambition
  4. Ethical behavior of management
  5. Competition from companies with the same industry
  6. Risk, opportunities

So, you have an overview of the business of the company to predict future cash flow of the company. Now we will try to predict the future cash flow of the Info Edge. So, to predict the future analysis of the company you have to do a detailed analysis of the company.

Info Edge is an internet company.

  • Info Edge launched its many products during the internet boom to take advantage of that eg- Naukaari.com, Shiksha.com, Jeevansathi.com, 99acres.com these are the products of Info Edge.
  • These companies are at the top in their segments.
  • Info Edge buys good companies at a cheap valuation to maintain its market position.
  • It continuously invests in good startups.
  • Strong balance sheet, strong financials, lot of hidden assets, strong investment portfolio.
  • After doing fundamental analysis of the company and after seeing the future planning and future aspects of the company, we conclude that the Info Edge will be going to do well in the future.

Management of the company is also good, founder of Info Edge Mr. Sanjeev Bikhchandari is involved in most of the philanthropic activities. He recently started a university in Haryana with 11 others and the aim of that university to change the education system.

Now,

Calculation of Free Cash Flow

Step 1 – To calculate the free cash flow at least past 3 to 4 years of the company –

YearFree Cash Flow (in Crore)
FY 2019248
FY 2018238
FY 2017197

Step 2 – Average cash flow of the company –
Avg = 248+238+197 / 3 = 227 crores.

Now the next step is to predict the future cash flow of the company. To predict you have to check the full financial statements and do a fundamental analysis of the company and then predict the future cash flow of the company.

Then the predicted cash flow of the company is —>

Cashflow the Info Edge will increase by 15% per annum from 2020-2029.

YearFree Cash Flow (in Crore)
FY 2020227+15%=261
FY 2021261+15%=345
FY 2022300+15%=345
FY 2023345+15%=396
............................
FY 2029799

Now convert the future value into present value means, now calculate it according to the inflation rate.

  • Present value= Amount / (1+ Discount rate)n
  • Amount = future cash flow
  • Discount rate: You can use opportunity cost as discount rate.
  • Opportunity cost: If you invest in an asset in which the risk is almost zero eg. Government bonds instead of info edge, then how much returns you will get in that assets is your opportunity cost.
  • In government bonds you can get the returns around 8% so, 8% is opportunity cost.
  • n = number of years.

Now,

Calculation of Present Value of Future Free Cash Flow Of Info Edge

  • Present value FY2020= 261/ (1+8%) = 241 crores
  • Similarly, present value FY 2021= 300/ (1+8%) = 257 crores.

Similarly, you can calculate all the present value for future free cash flows.

Financial YearFree Cash Flow (in Crore)Present Value (in Crore)
2020261241
2021300257
2022345273
2023396291
2024455309
2025509320
2026570332
2027638344
2028714357
2029799370
Total = 3094 Crores

Let assume after 10 years Info Edge will sell itself to another company. Now, assume the Info Edge will sell the 15 times of its free cash flow value in 2029.
370 crores X 15 = 5550 crores
Plus, the excessive capital and cash & cash equivalents of the company.
Let assume,

  • Excessive capital + cash & cash equivalents =1000 crores
  • Present value = 1000/ (1=12%)10 = 463.8 crore
  • Valuation (total) = 9108 crores
  • Now the valuation of Info Edge by DFC method is = 9108 crores.
  • There are a lot of assumptions.
  • Current market cap. of Info Edge is 27000 crores
  • Intrinsic value = valuation/ total no. of shares = 9108 / 121766159 available in annual report.
  • Intrinsic value = 747

According to our analysis, the intrinsic value of Info Edge is Rs.747 but the current share price is Rs.2273. It means the share price is overvalued.

Now, the question arises if a share price is overvalued by the DFC method then should invest in that company?

  • It depends on a lot of factors and to understand these factors, we have to understand one more method called the growth investing method (Invented by Philip fisher).

“I am 85% Benjamin Graham and 15% Philip Fisher” – Warren Buffett
It means – He 85% follows value investing and 15% growth investing.

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