Fundamental Analysis
14.1 – The Stock Price
Firslty, We discussed stage 1 and stage 2 of equity research in the previous chapter. Understanding the business was the focus of stage 1, and comprehending the company’s financial performance was the focus of stage 2. Only those who are convinced by the conclusions of the first two rounds may move on to step 3. The valuation of stock prices is covered in Stage 3.
Only when a great business is acquired at a great price is an investment deemed to be a great investment. In fact, if you can get a terrific deal on it, I’d go so far as to suggest that buying a subpar company is fantastic. This just serves to highlight the importance of “the price” in terms of investing.
The purpose of the following two chapters is to clarify “the price” for you. The price of a stock can be estimated using a valuation method. You can determine the company’s “intrinsic value” with valuation per se. Undoubtedly, The “Discounted Cash Flow (DCF) approach” is a valuation method that we employ to determine the company’s intrinsic value. The intrinsic value as determined by the DCF approach involves assessing a company’s “perceived stock price” while taking into account all potential future cash flows.
The DCF model is composed of a number of principles that are interconnected. Naturally, we must first comprehend each of these ideas on its own before applying them to DCF. We will first learn about the fundamental DCF concept known as “The Net Present Value (NPV)” in this chapter, after which we will learn about the other DCF ideas before learning about DCF as a whole.
14.2 – The future cash flow
The DCF model’s central idea is future cash flow. A straightforward example will allow us to comprehend this.
Let’s say Vishal sells the best pizzas in the area. His love of making pizzas inspires him to innovate. He creates a pizza oven that bakes pizzas automatically. He only needs to place the components for a pizza in the slots supplied, and within five minutes, a fresh pizza will emerge. He calculates that he can generate Rs. 500,000 in annual earnings and that the machine will last 10 years with this one.
George, a buddy of his, is a big fan of Vishal’s pizza maker. George offers to buy it because it is so bad.
Besides, What do you believe should be George’s minimum price to Vishal in order to purchase this machine? We must first determine how economically beneficial this machine will be for George in order to respond to this question. If he purchases this equipment today (2014), it will bring in Rs. 500,000 for him every year for the following ten years.
Especially, I was hoping you could take notice that I’ve assumed the machine will begin producing money in 2015 out of convenience.
It is obvious that George will make Rs. 50,000,00 during the course of the following ten years, after which the machine will be useless. At this point, one thing is certain: whatever the price of this gadget is, it cannot be higher than Rs. 50,000,000.
Consider whether it makes sense to pay a price that exceeds the economic advantage that an entity provides.
Let’s imagine Vishal asking George to pay “Rs. X” to the machine in order to move forward with our calculation. At this point, let’s say that George has two choices: either invest the same amount of money in a fixed deposit program that ensures his capital and gives him an interest rate of 8.5 percent or pay Rs. X and buy the machine. Assume George chooses to purchase the machine over the fixed deposit option. This suggests that George has lost out on the chance to earn risk-free interest of 8.5 percent. This represents the “opportunity cost” of choosing to purchase the device.
We have determined three significant pieces of information thus far in our attempt to determine the pricing of the robotic pizza maker:
First of all, Over the following ten years, the pizza company will generate Rs. 50,000,00 in total cash flow.
secondly, Since the whole cash flow is known, it also follows that the cost of the machine should be lower than the cash flow it generates overall.
Thirdly, The investment option of earning 8.5 percent interest is the opportunity cost of purchasing the pizza machine.
Let’s continue while keeping the aforementioned three things in mind. Now let’s concentrate on cash flows. We are aware that George will profit from the machine for the following ten years, earning Rs. 500,000 years. Consider this: George is looking toward the future in 2014.
What is the current value of the Rs. 500,000 that he will receive in 2016?
What is the current value of the Rs. 500,000 that he would receive in 2018?
What is the current value of the Rs. 500,000 that he will receive in 2020?
How much, on average, is the present value of the future cash flow?
Surely, These questions can be answered by considering the “Time value of money.” In other words, I would be in a better position to price that machine if I could determine the value of all the projected cash flows from it in terms of today’s value.
Apart From this, Please be aware that in the section after this one, we will depart from the pizza issue.
14.3 – Time Value of Money (TMV)
Definitely, The time value of money is incredibly important in the world of finance. Almost all financial concepts use the TMV in some way. The time value of money is relevant in all areas, including discounted cash flow analysis, financial derivatives pricing, project financing, calculating annuities, etc. Consider the “Time value of money” as the engine, and the “Financial World” as the car itself.
Importantly, The idea of the time value of money is based on the idea that the value of money changes with time. In other words, a hundred rupees now may not be worth one hundred rupees in two years. In contrast, a hundred rupees in two years won’t be worth a hundred rupees now. There is always a window of opportunity as time passes. For that chance, money must be accounted for (adjusted).
Moving the “money today” through the future is necessary if we need to determine what the worth of our current currency would be in the future. The “Future Value (FV)” of the money is what is meant by this. The future money must be converted back to today’s terms if we must determine the value of money that we anticipate receiving in the future in terms of today. The “Present Value (PV)” of money is what is meant by this.
Eventually, Both times, the money must be adjusted for opportunity cost due to the passage of time. Compounding is the term used to describe this adjustment when determining the future worth of a financial asset. When we need to determine the present value of money, the process is known as “discounting.”
For that reason, I will give you the formula needed to compute the FV and PV without going into the really easy maths involved.
Example 1: Assuming an opportunity cost of 8.5 percent, what is Rs. 5000/- worth in 2014 dollars five years from now?
We are attempting to determine the future value of the money we currently possess, which is a case of future value (FV) computation.
Future Value = Amount * (Opportunity Cost Rate + 1) Age in years.
= 5000 * (1% plus 8.5%) 5
= 7518.3
This suggests that assuming an opportunity cost of 8.5 percent, Rs. 5000 today is equivalent to Rs. 7518.3 after 5 years.
Example 2: Assuming an opportunity cost of 8.5 percent, how much is Rs. 10,000/- in receivables worth today?
As we attempt to calculate the present value of future cash receipts in terms of today’s value, this is unmistakably a case of present value (PV) computation.
Amount / (1+Discount Rate) Equals Present Value Ages in years
10,000 divided by 1 plus 8.5% ^ 6
= 6129.5
Assuming a discount rate of 8.5 percent, this indicates that Rs. 10,000/- payable after 6 years is equivalent to Rs. 6,129.5 today.
Example 3: If I rephrase the first example’s question, how much is Rs. 7518.3 in receivables worth today at an opportunity cost of 8.5 percent?
We are aware that doing so necessitates computing the present value. Additionally, since we performed the opposite of this in Example 1, we are aware that the correct response is Rs. 5000. To verify this, let’s calculate the present value:
= 7518.3 / (1 plus 8.5%) 5
= 5000.0
Lastly, I suppose we are now prepared to return to the pizza problem, assuming you understand the idea of the time worth money.
14.4 – The Net Present Value of cash flows
We are still determining how much the pizza maker will cost. We are aware that in the future, George is qualified to receive a stream of cash flows as a result of owning the pizza machine.
How much is the future cash flow worth in terms of today’s money? is a query we previously posed. Please allow me to repeat it.
As can be seen, the cash flow is evenly distributed over time. Each future cash flow that is due must be discounted with the opportunity cost in order to be calculated.
Clearly, The term “Net Present Value (NPV)” refers to the total present value of all future cash flows. In this instance, the NPV is Rs. 32,80,842. This also indicates that the total present value of all future cash flows from the pizza machine is Rs. 32,80,842. This is roughly how much the pizza machine should cost George if he had to purchase it from Vishal. George must make sure the price is Rs. 32,80,842 or less, but definitely not more.
Consider this: What if a business took the place of the pizza machine? Can we discount every future cash flow the company generates to determine the value of its stock? Yes, we can accomplish this, and under the “Discounted Cash Flow” model, we actually will.
CONCLUSION
- Firstly, We can estimate a stock’s price using a valuation model, such as the DCF model.
- Next, The DCF model is composed of a number of interconnected financial ideas.
- As you know, One of the most important financial concepts is the “Time Value of Money,” which is used in the DCF technique among other economic theories.
- In Fact, The worth of money cannot be treated uniformly through time, therefore its value in today’s terms won’t necessarily be the same at some point in the future.
- However, We must “time travel the money” after taking opportunity cost into account in order to compare money over time.
- Generally, The estimated value of the money we have today at some point in the future is known as the “future value of money.”
The present value of money calculates the amount of money due in the future based on its current value.
Lastly, The total of all the present values of the future cash flows is what is known as the Present Net Value (NPV) of money.