Now that you’re properly prepped about the different valuation methods and the due diligence required as a part of your pre-valuation exercise, it’s time to move into the big leagues. Here’s where we’ll answer the main question – How to build a valuation model? Well, the details of how to build a stock valuation model depend on the method you’ve chosen and sometimes, on the company being valued.
The DCF method, which you read about in an earlier chapter, is one of the most intricate valuation methods. Let’s use that as a prop to determine how to build a valuation model.
DCF model: The process of valuation
As we already saw in an earlier chapter, these are the main steps involved in the DCF valuation process.
- Determine the forecasting period.
- Calculate the free cash flows to the company over the course of the forecasting period.
- Calculate the rate at which you’ll discount the future cash flows.
- Determine the terminal value of the business.
- Discount the future cash flows and the terminal value to arrive at the present value of the company.
But before we get around to performing the above calculations, we need to get some numbers ready, so the actual DCF process is smoother. Let’s look at these one by one.
The numbers needed to build your DCF valuation model
To learn how to build a stock valuation model using the DCF method, these are the metrics you need to get started.
- The free cash flow (FCF) for the current year
- The growth rate to project FCFs for the forecast period
- The terminal growth rate needed to determine the terminal value
- The discount rate at which you’ll discount the future cash flows
To understand the nitty-gritties of how to build a valuation model, let’s take the case of Eicher Motors. Say we’re going to build a valuation model from the financial year 2019-20 and see if the company is overvalued or undervalued. Here’s how we’ll calculate the FCF for that year.
A. Calculation of the free cash flow for the year from which you’re forecasting
Recall the formula for FCF from the earlier chapter? Well, here it is.
Start with: | EBIT x (1 – tax rate) |
Add: | Non-cash charges like depreciation and amortisation |
Add/subtract: | Changes in working capital |
Subtract: | Capital expenditure |
Result: | Free cash flow for that period |
Now, let’s get the data for this read. Take a look at the screenshot below. It’s from the annual report of Eicher Motors for the year 2019-20.
- So, here, the EBIT for the financial year 2019-20 is Rs. 1,825.86 crores.
- The depreciation for that year is Rs. 377.92 crores.
What about the changes in working capital and the capital expenditure? Let’s calculate those metrics too.
The working capital is calculated according to this formula.
Working capital = current assets - current liabilities
Changes in working capital refer to the changes in this metric between the previous year and the year for which we’re calculating the FCF. So, we need to compute the working capital for financial years 2018-19 and 2019-20.
Particulars | Financial year 2018-19 (in Rs. crores) | Financial year 2019-20 (in Rs. crores) | |
A | Current assets | 997.62 | 933.12 |
B | Current liabilities | 1,978.24 | 1,861.12 |
C | Working capital (A-B) | (980.62) | (928) |
Change in working capital for the year 2018-19 [-928 -(-980.62)] | 52.62 |
So, the change in working capital for the year 2019-20 is Rs. 52.62 crores.
What about the capital expenditure for the year 2019-20? This screenshot from Eicher’s financials will give you the details.
As you can see, the capital expenditure for the year is Rs. 555.19 crores.
Using these metrics, let’s calculate the free cash flow for Eicher Motors for the year 2019-20.
Step | Particulars | Calculation | Result (in Rs. crores) |
Start with: | EBIT x (1 – tax rate) | 1,825.86 (1-25.168%) | 1,366.32 |
Add: | Non-cash charges like depreciation and amortisation | + 377.92 | 1,744.25 |
Add/subtract: | Changes in working capital | + 52.62 | 1,796.87 |
Subtract: | Capital expenditure | - 555.19 | 1,241.68 |
Result: | Free cash flow for that period | 1,241.68 |
Now that we’ve calculated the free cash flow for the current year, it’s time to identify the three important rates associated with the DCF model - the growth rate for the forecast period, the terminal growth rate and the discount rate.
B. The growth rate to project FCFs for the forecast period
This is the rate at which you expect the cash flows of Eicher Motors to grow during the forecast period. Here, it’s advisable to be conservative rather than optimistic, since we’re venturing into an area that’s futuristic. Nevertheless, there’s one way to approach this rate that can get you as close to the real metrics as possible. Here, you basically calculate the FCFs for the past 5 years or so, and calculate the rate at which the cash flow has grown. Then, taking an average of those growth rates, you can arrive at the growth rate assumed for the DCF model.
Eicher’s past performance has been quite impressive. But although the FCFs were all positive in the previous years, there were dips in the cash flow. And Eicher Motors, being a company that’s already well-established, may not grow at the same rate as younger companies.
So, to play it safe, let’s assume a growth rate of 10% for the forecast period.
C. The terminal growth rate needed to determine the terminal value
The terminal growth rate is the rate at which the company is expected to continue to generate cash flows beyond the forecast period. Here as well, it’s best to be as conservative in your estimate as you can. A good rule of thumb is to never use a rate that’s higher than the economy’s GDP.
Let’s assume a terminal growth rate of 3%.
D. The discount rate at which you’ll discount the future cash flows
Okay, so you have the growth rates. Now, what about the discount rate. There are two options to get this metric.
- Option 1: You can calculate the Weighted Average Cost of Capital (WACC) and use that rate as the discount rate.
- Option 2: You can use the risk-free rate in the economy as the discount rate. The risk-free rate is essentially the rate of return of an investment with zero risk. In the Indian economic scenario, you can consider the return on government bonds. Currently, the figure is around 5%.
For the purpose of our valuation model, we’ll take this second option.
So, let’s consider a discount rate of 5%.
Now that we have all the metrics, it’s time to get to the actual valuation process. Let’s take it step by step.
Valuation of a company using the DCF model
Here’s a quick recap of the number’s we’ve assumed.
Particulars | Assumed/computed value |
Free cash flow for the year 2019-20 | Rs. 1,241.68 crores |
Growth rate for the forecast period | 10% |
Terminal growth rate | 3% |
Discount rate | 5% |
Step 1: Determine the forecasting period
The forecasting period is the period for which you’ll project the free cash flows at the assumed growth rate. Some analysts and investors take 10 years. Some take 7. Others take 5. It’s really quite subjective.
For the purpose of our DCF valuation, we’ll take a forecasting period of 5 years.
Step 2: Calculate the free cash flows to the company over the course of the forecasting period
Year | Growth rate | Free cash flow (in rupees crores) | Comments |
Base year (2019-20) | 1,241.68 | As computed earlier | |
Year 1 (2020-21) | 10% | 1,365.85 | = 1,241.68 x (1 + 10%) |
Year 2 (2021-22) | 10% | 1,502.43 | = 1,365.85 x (1 + 10%) |
Year 3 (2022-23) | 10% | 1,652.67 | = 1,502.43 x (1 + 10%) |
Year 4 (2023-24) | 10% | 1,817.94 | = 1,652.67 x (1 + 10%) |
Year 5 (2024-25) | 10% | 1,999.74 | = 1,817.94 x (1 + 10%) |
Step 3: Calculate the rate at which you’ll discount the future cash flows
Now, this calculation will be essentially if you decide to adopt the WACC as the discount rate. But since we’ve chosen the other alternative, we already have our discount rate: 5%. So, let’s move on to the next step as you learn about how to build a stock valuation model.
Step 4: Determine the terminal value of the business
Remember the formula for calculating the terminal value of a business? Let’s look at it once more.
Terminal value = [The projected free cash flow in the final year of the forecast period x (1 + terminal growth rate)] ÷ [discount rate – terminal growth rate]
Using this formula, here’s what we get.
Terminal value:
= [1,999.74 x (1 + 3%)] ÷ [5% - 3%]
= [1,999.74 x 1.03] ÷ 2%
= 2,059.73 ÷ 2%
= 1,02,986.50 (in rupees crores)
Step 5: Discount the future cash flows and the terminal value to arrive at the present value of the company
You now have the free cash flows for the forecasting period and the terminal value of the company for the period after that. The next step is to discount all of these numbers to their present value. This formula can help you here.
Present value of any cash flow ‘n’ years from today = cash flow ÷ (1 + discount rate)n
Using this formula, let’s discount the free cash flows and the terminal value.
Year | Amount of FCF or terminal value (in rupees crores) | Discount rate | Present value of the cash flow | Comments |
Year 1 (2020-21) | 1,365.85 | 5% | 1,300.81 | = 1,365.85 ÷ (1 + 5%)1 |
Year 2 (2021-22) | 1,502.43 | 5% | 1,362.75 | = 1,502.43 ÷ (1 + 5%)2 |
Year 3 (2022-23) | 1,652.67 | 5% | 1,427.64 | = 1,652.67 ÷ (1 + 5%)3 |
Year 4 (2023-24) | 1,817.94 | 5% | 1,495.62 | = 1,817.94 ÷ (1 + 5%)4 |
Year 5 (2024-25) | 1,999.74 | 5% | 1,566.85 | = 1,999.74 ÷ (1 + 5%)5 |
1,02,986.50 | 5% | 80,692.62 | = 1,02,986.50 ÷ (1 + 5%)5 | |
Sum of all present values | 87,846.29 |
So, that brings us to the end of our exercise of valuing Eicher Motors. What does the sum of all the cash flows and the terminal value represent? The figure Rs. 87,846.29 crores essentially represents all the expected cash flows the company shall generate in the future.
Now, how do we go from here to valuing the company’s shares? Well, as you saw in the chapter on DCF earlier, we need to find the value of equity. And here’s the formula for this.
Value of equity = Value of the company – Value of debt
To recap, the value of debt is basically the sum of all the borrowings in the company’s name as on the date of valuation. When you subtract the value of this debt from the company’s value, you get the actual value of the equity. This is what you will get to enjoy if you invest in the company’s equity.
Let’s look at the annual report of Eicher Motors to get the value of debt.
So, since the net debt is nil, we’ll take the present value calculated earlier as the value of the company: Rs. 87,846.29 crores.
Wrapping up
This is the crux of how to build a valuation model using the DCF method. But what comes next? How do you actually determine if a company is overvalued or undervalued? And how accurate is that conclusion? These are some of the important areas that we’ll cover in the next chapter. Keep reading to get to know the whole picture.
A quick recap
- To learn how to build a stock valuation model using the DCF method, you need the free cash flow (FCF) for the current year, the FCF growth rate, the terminal growth rate and the discount rate.
- The FCF for the current year is the basis for projecting your cash flows.
- The growth rate must be as conservative as possible.
- The terminal growth rate is best kept below or equivalent to the GDP rate.
- The discount rate can either be the WACC or the risk-free rate in the economy.