8.18 Fundamental Analysis: DCF

Also called fundamental analysis, discounted cash flow (DCF) analysis estimates a company's future cash flows, aggregating the flows in today's money terms (i.e. allowing for inflation).

The formula is simple:

Because predictions become more uncertain into the future, and cash flows themselves become heavily discounted, it is not usual to sum the series to infinity but consider only the first 10 or 25 years in calculating the Discounted Cash Flow (or, as it's often called, Net Present Value: NPV).

Introduction

Gross cash flows are the profits of a company before tax. They may be invested by the company, returned to banks that provided the company with business loans, given to shareholders as dividends or used to buy back shares.

Free cash flows are profits after payment of tax and debt interest. Tax may be imposed on sales, be a value added tax and/or a tax levied on company profits.

Crucial to the DCF is the so-called 'cost of capital', which is the annual rate of return required by investors to compensate them for the risk they take on with a project, and for suffering inflationary losses when they lend or invest money. {5} The cost of capital varies from some 2-4% for risk-free government bills, and rises to 10-15% for publicly quoted entities. Private equity costs of capital are higher, often around 20%, but exceeding 50% in fledgling Internet companies with no proven business model or track record. Clearly, to be worthwhile, the expected return must be greater than the cost of capital, or the money is better invested elsewhere.

Textbooks cover the ways of calculating the cost of capital, which group into three.

1. Model the company on similar examples in its market sector, using stock market data and cost of capital formulae like CAPM, or the Fama and French four factor model: formula-based determination. The CAPM formula is:

Expected rate of return = Rrf + Beta(Rm-Rfr)

where Rrf is the risk-free rate of return, and Rm is the market rate of return. Beta is the measure of the company's volatility relative to the market, and is quoted on many business websites.

2. Calculate the cost of capital by analysis of the company, isolating the individual components and their Beta values: component-based determination.

3. Derive the cost of capital from the market valuation of the company and its forecast or expected earnings: reverse-calculation method.

Examples

Some familiarity with financial statements is required, and — since companies may present their results a little differently while still complying with generally accepted accounting procedures (GAAP) — there are preferred ways of dealing with inventories, receivables, amortization of goodwill and other imponderables: all set out in the standard texts, {6-8} though the rules change. Though in essence simple, analyses are time-consuming and need sensible assumptions. Analyses for some companies are available as an online service. {9}

DCF analysis is no more accurate than the cash flow estimates and assumptions fed into the formula. Though investment banks will make these assessments for any company at the request of clients, the approach is more suited to long-established companies whose businesses are understood and which face relatively steady futures. Nonetheless, the method has been used to value Internet companies, even those with erratic performances and problematic business models, though the results often speak for themselves. The table compares detailed estimates made for Amazon in 2001 {2} against figures subsequently reported. {3} {4})

Predicted Sales

Predicted Net Income

Year

Reported Sales

Reported Net Income

3,486

-38

2002

3.9 bn.

-149 m

3,904

-18

2003

5.3 bn

35 m

4,373

35

2004

6.9 bn

588 m

4897

98

2005

8.5 bn

359m

5,485

173

2006

10.7 bn

190 m

6,143

263

2007

14.8 bn

476 m

6,881

368

2008

19,2 bn

645 m

7,706

493

2009

24.5 bn

902 m

8,631

639

2010

34.2 bn

1.15 bn

9,667

627

2011

48.1 bn

631 m

10,827

645

2012

tba

tba

Amazon in 2001 was a simple though large online bookstore, not today's giant providing everything from electronics to auto parts, ecommerce fulfillment, logistics platforms, advertising, and an Internet startup incubator.

DCF analysis can also be used to compare companies whose performances are known. Kim Walsgard looked at the cash flows of two Swedish (Unibet and Net on Net) and two Korean ( Neowiz and Interpark) Internet companies over the 2001-5 period. {14} The companies and national infrastructure were broadly similar. Net on Net and Interpark were e-retailers, and Unibets and Neowiz were content & portal companies. The weighted average cost of capital (WACC) was 6% for Unibet, 4.6% for Net on Net, 6.4% for Neowitz and 7.2% for Neopark. The calculations are set out in the paper. Walsgard's findings were:

 

Unibet

(SEK)

Net on Net

(SEK)

Neowiz

(KRW)

Interpark

(KRW)

NPV

5,809,168,000

564,791,000

418,867 million

462,547 million

Number of shares

at year end 2005

28,125,092

6,015,680

7,492,310

43,332,093

NPV per stock

206.55

93.89

55,906

10,674

Stock price

at year end 2005

161.00

91.50

48,750

11,600

NPV per stock

/Stock price end 2005

1.28

1.03

1.15

0.92

Market capitalizations (number of shares x stock price) were fairly close to the NPVs. Unibet and Neowiz were forecasting faster growth and their NPV/stock price ratios were accordingly a little higher.

Importance

The calculations are simply performed with calculators or spreadsheets, the last also allowing 'sensitivity analysis', i.e. the company can be valued with different assumption input as data, and the crucial factors identified. DCF analysis is important in project evaluation, but the value often lies not so much in getting 'the required return' as discerning what needs closer attention in the planning and implementation stages.

Points to Note

1. Cost of capital and NPV.
2. Limited value of NPV estimates of Internet companies that model cash flows far into the future.
3. Market capitalization and NPV: what the ratio says.

Questions

1. Explain the Net Present Value of a company and the steps needed to arrive at a reliable figure.
2. What difficulties to fundamental analysis are presented by Internet companies?
3. Outline a study comparing NPVs with market capitalizations.

Sources and Further Reading

Need the references and resources for further study? Consider our affordable (US $ 4.95)  pdf ebook. It includes extensive (3,000) references, plus text, tables and illustrations you can copy, and is formatted to provide comfortable sequential reading on screens as small as 7 inches.

   Get your eBook here.