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

1. Discounted Cash Flow. Inc. Accessed September 2012.
2. Internet Valuation: The Way Forward by John Briginshaw. Palgrave, 2002. pp. 19-186.
3. 4.2 DuPont Analysis of Amazon.com. Financial Trading System. 2011.
4. Amazon.com (AMZN). Wikinvest.
5. Cost of Capital. Wikipedia. June 2012.
6. Discounted Cash Flow: A Theory of the Valuation of Firms by Lutz Kruschwitz and Andreas Loeffler. Wiley. 2005.
7. Financial Modeling by Simon Benninga. MIT Press. 2008.
8. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset by Aswath Damodaran. Wiley. 2001.
9. Verizon Communications Inc. (VZ). Stock Analysis on Net. September 2012. Detailed entry on one company.
10. The Application of Fundamental Valuation Principles to Property/Casualty Insurance Companies by Wayne E. Blackburn, Derek A. Jones, Joy A. Schwartzman and Dov Siegman. Casuality Actuarial Society. Undated consideration of valuation by EVA and DCF.
12. Ibbotson Cost of Capital Resources Center . Morning Star. Some 162,000 PDF and Excel reports covering 406 industries and 10,000 U.S. companies.
13. Are Internet Stocks Fairly Valued? A White Paper. Berkeley Course Paper. 1999 .
14. Internet Business Valuation : Case Study of two Korean and two Swedish Internet Companies using Adjusted DCF Valuation Model by Mijung Kim Walsgard. School of Business: Stockholm University. 2006.