In all my posts on investment ideas, I typically refer to the instrinsic value of the company. The definition and concept is deceptively simple, application takes a lifetime.

What is intrinsic value – It is the total free cash flow the company will produce from now to closure of the firm. Discounting these cash flows gives the intrinsic value.

I will not be able to give a complete rundown on the DCF (discounted cash flow) computation. That could be another post, when I am really in mood to bore everyone to tears ðŸ™‚ . However the formuale for the computations is present in my valuation template – see the tab â€˜DCF’

You can find the formulae here. The key parameters are free cash flow, discount rate, terminal values and growth rate. There are volumes written on each parameter and I will not get into the pros and cons of it. Let me give you how I calculate each. You can find the mechanics for each in my worksheets for companies.

Free cash flow = Net profit (after adjusting for all one time gains / losses)+ depreciation – maintenance capex

Discount rate = around 12-13 %. That’s the hurdle rate for me. I don’t use any risk premium above that. Discount rate is a research topic in itself. I prefer to use a rough approach though and not tie myself up in academic acrobatics.

Growth – self-explainatory

Terminal value – It is the value of the company from the nth year ( n-1 year are the no. of CAP years) onwards. I would suggest looking at some textbook for more details as it is difficult to explain it in a short post.

Â I take it as 12 times Free cash flow of the previous year. Simple formulae for terminal value is NOPAT (net operating profit after tax)/ WACC (weighted average cost of capital).Â However let me warn you that the DCF calculations are very sensitive to the terminal value and it is important to be conservative on this parameter.

Once you have worked these numbers, you can plug them into a spreadsheet and get the intrinsic value. As you can see all these numbers are estimate and hence intrinsic value is an estimate too. The trick is in the assumptions you make. You have to be careful in making conservative assumptions, otherwise the DCF calculation could give you inflated numbers. That’s why a good valuation requires an indepth understanding of the company and its economics.

Discounted cash flow (DCF) analysis is the most fundamental way of calculating the instrinsic value. The other approaches such as PE, relative valuation which depends on comparing the valuation with other companies in the same industry etc are indirect valuation approaches. They can be used an input into the valuation process, but should not be the sole approach

[…] scalability is a critical factor in valuation. As I detailed on my post on intrinsic value, the DCF formulae can be used to calculate this number. There are two key variables in the formuale […]