Common Terminologies Used in Forex Markets
Financial markets have their own terminologies. The Forex market has a number of terms which it shares with other financial markets but which mean different things in the Forex market. Also, there are some words which are completely unique to Forex. In this article, we have a closer look at Forex terms. These terms will […]
Leveraged Buyouts in Investment Banking
Anyone working in the investment banking industry for a few years has definitely come across the term “leveraged buyouts.” It creates huge risks, as well as investment opportunities. Over the years, many investment banks have been involved in financing several big-ticket leveraged buyouts. In this article, we will explain in detail what a leveraged buyout […]
Debt to Equity Ratio – Meaning, Assumptions and Interpretation
The debt to equity ratio is the most important of all capital adequacy ratios. It is seen by investors and analysts worldwide as the true measure of riskiness of the firm. This ratio is often quoted in the financials of the company as well as in discussions pertaining to the financial health of the company […]
A Primer on Private Placements
When we think about investment banks, as well as the activities that they undertake, we tend to think about initial public offerings, debt syndication, and other such activities that are very visible to the public eye. However, the reality is that a lot of investments that are routed via investment banks are actually private placements. […]
Team Sponsorship: Advantages and Disadvantages
In the previous articles, we have already come across the concept of team sponsorship. We have seen how teams can sell different types of sponsorships in order to raise money. This definitely ends up increasing the cash flow as well as the return on investment for the team. It also generally provides a positive return […]
In the past article we have seen how Discounted Cash Flow (DCF) is the most appropriate method of stock valuation because it is rational and objective. Now, it is time we have a look at the details of this model.
The basic of this model seems to be simple. Any company is only worth as much as it will generate in cash flows over its lifetime. So, we need to estimate the lifetime of the company, we need to estimate the cash that the company is expected to turn in during this lifetime. Then we should discount the cash flows reflecting the risk and time duration. Adding up those cash flows should give us the present value of the firm in theory!
Now, it is important to realize that we are discounting cash flows. We aren’t discounting profits. This is because, profits are subjective. Management has significant discretion over the amount of profits that it wants to report. Also, profits really are an opinion. Dividends on the other hand are just monies paid out to shareholders. Dividends do not reflect profitability. A company could go into loss but still pay a dividend. In fact, many companies do that! So, dividends also aren’t really a good barometer to judge the performance of a company.
Besides, the company can invest cash for further growth of their business. So the opportunity cost for the company really begins when cash comes in the door. Hence cash flow is used and hence the model is called discounted cash flow model.
Now, we earlier stated that the process begins with estimating the life of the company. Here is a real problem! The company does not have a finite life at all. The company is a legal person created by law. Legally they have an infinite life. This feature of a corporation is called perpetual succession. Now, this poses real problems when it comes to valuing shares because this means that our cash flows are expected to go on till eternity! How can you value an infinite series of future cash flow payments? Well, we cannot until we make some assumptions. Those assumptions are discussed below.
To arrive at a value for a company’s stock, we need to split the calculation into two parts. The first part is called the “horizon period”. This is the period for which we will estimate the cash flows with a good degree of precision. This period is generally 4 to 7 years and is the choice that an analyst needs to make. Since this is a finite series of cash flows we can easily discount it and come up with a finite value.
The remaining part of the life of the stock is considered to be a growing perpetuity. So the analyst must make an assumption regarding the constant rate of return that is assumed to be earned by the company till perpetuity. This constant rate must be less than the discounting rate. This makes it an infinitely decreasing series. Mathematically we can come up with a finite value for an infinite set of numbers if their value is decreasing. Hence, we can come up with a finite value for the perpetuity as well.
In the end we need to add up the value of the horizon period as well as the perpetuity to get the discounted value of cash flows. This is how the discounted cash flow model is used to arrive at a stock valuation.
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