Discounted cash flow (DCF) analysis is the single
most widely relied-on technique of securities
analysts for assessing a company’s prospects.
The process involves looking at likely future
cash flows and translating them into present day
value. To achieve the appropriate discounting,
the analyst must take into account the time value
of money.
Let us look at how you discount future cash flows,
for which you will need the company’s financial
statements to hand. You will start with the company’s
net operating cash flow (NOCF), which you may
find as follows.
Take the company’s earnings before interest
and tax. Deduct corporation tax paid and capital
expenditure, and add depreciation and amortization,
which do not represent movements in cash. Add
or subtract the change in working capital, including
movements in stock, in debtors and creditors,
and in cash or cash equivalents. This is the year’s
NOCF. It can be calculated for future years, and
reduced in value to present day terms by a discount
rate.
For DCF purposes, cash flows are likely to continue
beyond the period over which it is possible to
assess cash generation accurately. This can be
modelled through use of terminal value. Present
and future modelled cash flows, together with
the terminal value, make up the net present value
(NPV) once they have been discounted at an appropriate
cost of capital. The number of years over which
these cash flows are discounted, and the actual
future NOCF forecasts, will influence the NPV.
Besides this, the larger the discount rate used,
the smaller is the NPV.
Weighted average cost of capital (WACC) is often
used as the discount rate. Generally, companies
raise their capital through equity or debt. The
WACC represents the cost of capital to the company
weighted in terms of debt and equity. We can break
down the WACC into its two components. First,
the cost of debt is the current yield to maturity
on the company’s bonds. Second, the cost
of equity is commonly measured by the Capital
Asset Pricing Model (CAPM – pronounced CAPEM).
The CAPM finds the required rate of return on
a stock by comparing its performance with the
market. It expresses this return as equal to the
risk free rate of return plus the product of the
equity risk premium and the stock’s beta.
The formula is as follows:
Cost of equity = risk free state + (equity market
risk premium × equity beta)
The CAPM assumes that the market rewards investors
for acquiring investments which carry a larger
amount of market risk, which cannot be diversified
away. The higher a share’s market risk,
the higher is its so-called beta. If a share fluctuates
in line with the market, it will have a beta of
1.0. If it has a beta of 2.0 or 0.5, it will fluctuate
at twice or half the market level respectively.
Unfortunately, beta is an historical figure and
so not always reliable, so a portfolio of high-beta
stocks does not always outperform one of low-beta
stocks as it should. In practice, beta works better
over a period – decades rather than years
– or at times of major share price fluctuation
such as during a market crash.
According to the CAPM, investors are not rewarded
for taking unsystematic (ie company-specific)
risk because it can be eliminated through diversification.
This is in keeping with Modern Portfolio Theory
from which the CAPM originates.
The CAPM is a theoretical model. It assumes no
taxes or transaction costs, and that investors
see the same investment opportunities and have
a shared time horizon and expectation of return.
It assumes that investors may borrow and lend
at the risk-free rate of return and that investments
are properly and instantly priced according to
risk levels, and that market information is made
available instantly and free of charge to all
investors. In the real world, the theory is used
extensively, and adjustments can be made where
the assumptions fall short of the reality.
Several models
To make forecasting more likely to take into account
unforeseen events, analysts may plot DCF models
using several discount rates to present alternative
valuations. This approach is more useful analysis
than attempting a single DCF forecast. It acknowledges
that DCF analysis cannot always predict the future,
and it reduces the scope for abuse. In the past,
analysts have abused the DCF concept to promote
favoured companies on the basis of inflated expectations,
a practice that recent regulatory trends have
made much more difficult.
Qualitative factors
Some value investors focus purely on ratio and
DCF analysis, but it makes sense to mix these
with qualitative assessment.
Warren Buffett and Anthony Bolton, as value investors,
take the view that the franchise is more important
than the management. An average manager could
run a great franchise and a great manager could
not do much with a bad one, according to Bolton.
History shows that management with a strong track
record can help steer the company through difficult
times. Check the age of key managers. If the chief
executive is in his late forties, he or she is
young enough to stay with the company for the
foreseeable future, but mature enough to have
experience and judgement. Much older or much younger
could lead to problems, although there are plenty
of exceptions.
Steer clear of companies where managers have been
linked with failure or fraud. Bolton says: ‘I
used to think that if the business was good but
there’s a question mark about the management’s
integrity, I’ll buy. I’ve changed
my mind.
