Understanding Discounted Cash Flow Model (DCF) to Calculate Intrinsic Value

Investing in the stock market could be much more accessible nowadays as there are many resources and useful tools that help investors making an investment decision. In ShareInvestor WebPro and ShareInvestor Station, there are three new developed models which are Gordon Growth Model, Discounted Cash Flow Model and Discounted Earnings Model. Among all these models, they could help investors to find the intrinsic value of the particular stock — many complicated calculations and formulas to find the intrinsic value. ShareInvestor WebPro has simplified the process. It allows users to plug in the relevant figures and it automatically calculates the valuation of the company.

Today, we will talk about the Discounted Cash Flow Model to helps an investor assess the viability of a project or investment by calculates the Total Free Cash Flow based on the projected growth rate and discounts back to the present value. If the company value derived through Discounted Cash Flow Model is higher than the current market price per share, the investor shall start to monitor this type of company.

This model requires a positive free cash flow to derive the intrinsic value of a stock. If the free cash flow of the capital is a negative figure, this model cannot be applied. Let us look at “How to fill up the figures in ShareInvestor WebPro to get the intrinsic value for Air Asia Berhad” by using Discounted Cash Flow Model as an example.

1. Free Cash Flow Per Share (RM)

Free cash flow = Operating Cash Flow (CFO) – Capital Expenditures
Free Cash flow is the actual cash that would be available to the company’s investors after accounting for reinvestment in non-current capital assets by the company. The Free Cash Flow can be derived from the income statement and balance sheet of the company. On the other side, free cash flow also can be calculated by using the following formulas:-

By looking through this formula, it may sound complicated but ShareInvestor WebPro do provide automatic calculated of Free Cash Flow for you as shown as the picture below:

Based on the photo above, insert 0.0227 to the free cash flow per share column.
Note: You need to right-click the stock and choose financial, then you can found the free cash flow per share in the part of Per Share Data (Historical).

2. Cash Flow Growth Rate (%)

For the cash flow growth rate, we can use the industry average growth rate of the company in the model provided or we also can use the average growth rate for the company based on selected years. There is no right or wrong on which to be used. For Air Asia Berhad, I will use the industry average growth rate which will be automatically calculated as shown as the photo below: –

3. Years of Growth

A company CEO may project the years of growth and announce it to the investor during AGM (Annual General Meeting).
The other ways to are looking at the past industry growth cycle. If the industry sector usually tends to continue to grow for 5 years, you can take that numbers as a reference.
Let us assume that the year of growth is 5 years. Therefore, insert 5 years into years of growth column.

4. Discount Rate (%)

The discount rate is the required rate of return for investors. If he/she perceives the investment relatively risky, he may want to put a higher discount rate. For the public companies, there’s an assumption that the business was to continue to operate for longer compared to smaller private companies which may have a shorter life span.

To find the Discount Rate, we will use the Capital Asset Pricing Model (CAPM) formula as stated below.
Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for the assets. This model is also widely used for securities to generate the expected return for the stock. The risk-free rate in the CAPM will account for the time value of money.

The formula for Capital Asset Pricing Model is as follow:-

Risk Free Rate (Rf) = 0.041

We will obtain the risk-free rate from 10 years of Malaysia Government Bond by Google it which is 4.14% equivalent to 0.041 as shown as the picture below:-

Beta (β) = 1.112
Beta is used to measure volatility or systematic risk of a security. A beta of 1 indicates that the security price is moving together with the market. A beta of less than 1 means the security will be less volatile than the market. A beta which is greater than 1 indicates that the security’s price will be more volatile than the market.
For Beta of Air Asia Berhad, we will obtain it at the Factsheet from our ShareInvestor WebPro or ShareInvestor Station which is 1.112. I will choose the beta of (500days) which is 1.112 as common. There is no right or wrong choosing beta (75days) or beta (500days).

Note: Select particular stock and select FactSheet, and you will found Beta (500days) at the key statistic part.

Expected Market Return E(RM) = 0.066
We need to use Compound Annual Growth Rate to find the expected market return of the stock. Compound Annual Growth Rate is a useful tool which used to determine the annual growth rate on an investment which the values have fluctuated widely from one period to the next.
The formula for Compound Annual Growth Rate (CAGR) as follow:-

I will take 10 years of the stock to measure the expected market return from the Year 2009 to the Year 2019 for FBMKLCI.
Beginning Value for FBMKLCI in the Year 2009 = 878.30.
Ending Value for FBMKLCI in the Year 2019 is 1674.12 (On 10 Jan 2019)
Period from the Year 2009 to the Year 2019 = 10 years.

After we have the beginning value, ending value and number of years based on particular years in the FBMKLCI into the CAGR formula, the expected market return we get is 0.066. After we got all the figures, we can calculate the Capital Asset Pricing Model to get the Discount Rate.The discount rate we get is 6.89%. Therefore, I will round off and insert it as 7% into the Discount Rate column.

5. Terminal Growth Rate (%)

Terminal Growth Rate will be used to estimate the company’s growth beyond the projection period and will be used to calculate the terminal value of a company which will be expanding its future income beyond the initial few years’ projections.
Note: the terminal growth rate must always lower than the discount rate.

We will use Growth Rate of The Country Real Gross Domestic Product (GDP) for this year 2019 which is 4.6% equivalent to 0.046.
After we have all the info, we can key into our ShareInvestor WebPro or ShareInvestor Station platform and select calculate to get the intrinsic value of Air Asia Berhad. The intrinsic value for Air Asia Berhad is RM 1.01.

Now we know that Air Asia Berhad has an intrinsic value of RM1.01. The current market value of Air Asia Berhad is RM2.95. (based on 10 January 2019). Therefore, it indicates that Air Asia Berhad currently is overvalued since the current market value is larger than the intrinsic value of the company.

Written by Stella Goh | 11 Jan 2019.

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