7. Value a Stock

DCF - Discounted Cash Flow

• Identifying the Value of the stock for the identified great company

• Perpetuity - Equal amount at equal interval forever

• Companies that create perpetuity - Coke, Gillette

• Say, you invest 1cr in Bank or Bonds with 10% fixed interest rate. it would give 10L per year forever

• Means, here PV of 10L\year is 1cr

• Case-1: PV of constant Perpetuity = PMT/rate = 10L/10% = 1cr

• Now, Fair Value FV of 10L\yr is 1cr

• Suppose RBI require money and gives discount, pay 90L and it would give 10L\yr

• Suppose RBI doesn't require money and ask premium, pay 1.1cr and it would give 10L\yr

• Growing Perpetuity - Future Cash flow. Say Bonds ask you to invest 1cr and it would be give 10L\year growing at 5% per year. Assume 7% rate of return

• Case-2: PV of Growing Perpetuity = PMT/(Rate - G) = 1000000 (0.07 - 0.05) = 5cr

• Case-3: Suppose a company e.g. ITC says it would give 10L\yr contant perpetuity. Due to higher risk with stock, rate of return needs to be higher say 15%

  • B-School of thought

  • PV Constant Perpetuity = PMT\Rate = 1000000/0.15 ( Due to higher risk keep rate higher say 15%)

• Warren Buffer though

  • Rate is an perception, needs to be consistent logic. However different people might take different rate.

  • PV of Constant Perpetuity = PMT/Rate = 1000000/0.07 (Keep rate same as that of RBI 10 yr bond) = 1.42cr

  • However, wanna keep 50% margin of safety means, 1.42 cr\2 = 71L as Fair Value

• Case-4: Growing Perpetuity

  • PMT/rate - g = 1000000/0.7-0.5 = 5cr

  • Apply margin of safety, 5cr\2 = 2.5cr

• TBD

Value using FCF - e.g. ITC

• What should be the fair market value of ITC

• FCF = 75000 M

• PV of Constant perpetuity = PMT/rate = 75000/0.07 (RBI bonds rate) = 1072243 M INR, 1072 B INR

• Next year perpetuity = 75000 + 5% = 78809

• PV of Growing perpetuity = PMT/r-g = 78809/0.07-0.05 = 3940 B INR

• Margin of Safety = 3940/2 = 1970 B INR (Compare with Market Cap 3355 B INR)

Value with Faster to Slower Growth (5%)

• Example - ITC

• Identify the growth - Historical Data And Industry Reports

  • Historical Data Growth = 21% p.a. (May not be true for future growth)

    • FCF Average of 2008, 2009, 2010 = 18808 M INR (2009)

    • FCF Average of 2015, 2016, 2017 = 71787 M INR (2016)

    • Rate =rate(7,0,-18808,71787) = 21%

  • Industry Growth

    • Ciggrette Industry + FMCG Industry = Assume as 15% (Boston consulting etc)

    • Dont pick company report, pick industry report

  • Say 2018-2022, 5 yrs growth is 15%

  • Say 2022-2027, 5 yrs growth is 10%

  • Say 2028-forever growth is 5%, calculate growing perpetuity

  • 2028 FCF = 255290 (After 15% and 10% growth for 10 yrs)

  • FV at 2027 = PMT/rate - growth = 255290/0.07-0.05 = 12764480 (called as terminal value)

  • Calculate PV (by =pv formula) for every year

  • Sum of PV for all future year and divide by 2

  • Check if this value is less than current value

• TBD