How Will I Value The Stocks?

After much prevarication now it is time for me to dwell on my research methodology. I want to use discounted cash flow (DCF) method to value the stocks. It is a form of "fundamental analysis". This form of analysis is distinct from "technical analysis" or "charting" which looks at charts of prices and tries to find trends to predict where the price will be going ahead. Fundamental analysis claims greater depth of thinking since it looks at fundamental factors that impact stock prices. In DCF, for instance, various profit line items such as revenue, costs etc are forecast in to the future and the resulting cash flows is discounted back to the present to get the value.

So I will use DCF. An important aspect of DCF valuation is the forecasting. Since companies are considered going concerns, that is their winding up is not considered, the cash flows from their operations need to be forecast to an indefinite time in the future, i.e., infinity. Since it does not make sense to engage in a never ending process of predicting values of forecast variable for each year, after a point the values are expected to stabilize and follow a trend. The time horizon up to this point is called the forecast horizon. The cash flows after this point, when discounted to the end of the forecast horizon, add up to the terminal value. So the value from DCF can be expressed as the sum of the discounted value of the cash flows in the forecast period and the discounted value of the terminal value.   

For forecasting I will either use simple methods like expecting the CAGR (Cumulative Average Growth Rate) to continue in to the future, expecting the last year's value to hold, or just manually enter values, based on my hunch. For this I may refer to industry news and research items to better inform my arbitrariness. In certain cases I may defer to industry analyst's forecasts published elsewhere. The variables that will be forecast include mainly revenues and expenses, and they are expected not to change too drastically, or, if they change, then to do so in a random manner that would leave even the wise confounded. This is because the companies analyzed are large and their business models cannot be drastically altered with any great speed and if this is accomplished then the consequences become unpredictable. You can't turn a train around like you would a bicycle and if you do, it might just end up derailed.

Since I will be valuing equity, I can either calculate the future cash flows to equity directly or I can calculate the cash flows to the firm and subtract the debt from firm value thus calculated. So this leads to the question what are cash flows to equity and cash flows to firm. Which then begs the question what are equity and firm. Well, a firm can be lots of things. For me it is an entity that the published financial data (balance sheet, profit and loss statement and cash flow statement) that I will refer to correspond to. Since I want to focus on the Nifty, these would all be public companies. Details of other forms of organizing the firm can be obtained elsewhere.

A firm requires capital to function and this is raised by two means: equity and debt. Equity provides ownership and is more risky, since there is a chance that it can be wiped out if the business tanks. Debt is borrowed capital and is less risky since it is legally required to be paid off at agreed intervals and has an earlier claim on the firm’s assets if the company goes belly up. But the pay-off from debt is fixed at the agreed rate of interest while the equity can increase in value without bounds.

Once a firm starts functioning it generates revenue and incurs costs. Revenues come from sale of goods and services or profits from investments. Costs are incurred in a variety of ways and the classification of costs is an elaborate exercise that constitutes the preliminaries of cost management. I excuse myself of that burden. Broadly, the costs relate to making the goods and services, marketing and selling them, and paying off relevant stakeholders such as employees, debtors and the Government. What remains of the revenues after costs have been deducted is the net profit of the firm. This belongs to the shareholders, i.e., the owners of the equity. But it is not this cash flow that is discounted to get the equity value. Rather, a measure called free cash flow to equity (FCFE) has been constructed to facilitate getting an accurate picture of the cash flows that accrue to equity. This is because the calculation of the net profit involves non-cash and non-operating items which have to be accounted for before understanding what is the cash flow that actually comes to the shareholders. Since the starting point for my DCF analysis are the financial statements, the equation for FCFE is the same as that given by Wikipedia:

FCFE=Net Income + Depreciation and Amortization - Capex - Change in Working Capital + Net Borrowing

Depreciation and amortization are added back because they are a non-cash change in the value of some capital goods, investment in which was accounted for in some previous year in a lump-sum manner as the current capex is being accounted for in the FCFE equation in the current period. So is the case with working capital since an increase in the working capital lowers the cash available to the shareholders for the present but would lead to more revenues in the future (hopefully). Net borrowing that does not go into capex or change in working capital is a cash flow available to the equity holders so it is included in the FCFE equation.   

To discount the FCFEs of various years back to the present I use the equity cost of capital calculated from the CAPM equation, which is very popular and widely used. Details of the choices regarding the CAPM parameters, for instance the period for calculation of various parameters of the CAPM, are rather pedantic and I ignore them. My forecast horizon too would be ad hoc usually somewhere between 5 and 10 years. Terminal growth rate too would be chosen on a case to case basis with appropriate justification provided in each case.

This should sum up adequately my modus operandi with respect to the valuation procedure. Hence I conclude this post here.