Discounted Cash Flow Analysis: 5 Steps to Find the Best Stocks for Investing

This article is part 7 of the Fundamental Analysis section of our Stock Market Learning series created by SMJ. It offers a comprehensive and straightforward guide to selecting the best stocks for investing using a five-step approach and discounted cash flow analysis. Our goal is to help beginners understand these fundamental concepts and feel more confident about engaging in stock market investing.

Investing in the stock market can be a powerful way to build wealth over time. However, selecting the right stocks requires careful analysis and strategic planning. In the context of the Indian stock market, where economic dynamics and market conditions can vary widely, it is crucial to adopt a systematic approach to identify the best investment opportunities.

Combining these steps and DCF analysis, you will be equipped with the tools and knowledge to make informed investment decisions and potentially achieve significant returns in the Indian stock market.

What is Discounted Cash Flow (DCF) Analysis?

Discounted Cash Flow (DCF) analysis is a financial valuation method used to estimate the value of an investment based on its expected future cash flows. By projecting these future cash flows and discounting them back to their present value using a specific discount rate, DCF analysis helps determine whether an investment is likely to be profitable.

The primary purpose of DCF analysis is to assess the attractiveness of an investment opportunity. It provides a comprehensive method for valuing a company, stock, or project by considering the time value of money. This analysis helps investors and business managers make informed decisions about investments, acquisitions, and capital expenditures.

Components

1. Future Cash Flows –

•  The expected cash inflows and outflows from the investment over a specific period.

•  These cash flows can be derived from various business operations, investments, or financing activities.

2. Discount Rate –

•  The rate used to discount future cash flows to their present value.

•  Often, the Weighted Average Cost of Capital (WACC) is used as the discount rate because it accounts for the return expected by both equity and debt investors.

3. Present Value –

•  The current value of future cash flows after applying the discount rate.

•  Present Value (PV) is calculated to determine the worth of future cash flows in today’s terms.

Formula

The formula for DCF is –

Where –

Example Calculation

Consider an investment with the following projected cash flows and a discount rate of 10% –

Year	Cash Flow
1	₹1,00,000
2	₹1,50,000
3	₹2,00,000

The DCF calculation would be –

Since the NPV is positive, the investment is considered profitable.

For example, if an Indian IT company like TCS or Infosys has stable and predictable cash flows, DCF analysis can help determine whether its current market price reflects its true value. By comparing the intrinsic value calculated through DCF with the market price, investors can make informed decisions about buying, holding, or selling the stock.

Also Read: Mastering Cash Flow Statements: A Guide to Reading and Analyzing

5 Steps to Find the Best Stocks Using DFC

Step #1 – Identify Potential Stocks

The first step in selecting the best stocks for investing is identifying potential candidates. This involves thorough research and screening to filter out stocks that meet specific criteria and align with your investment goals.

Using Stock Screeners and Filters Based on Criteria. To streamline the process, use stock screeners and apply filters based on various criteria such as –

• Market Capitalization – Determine whether you are interested in large-cap, mid-cap, or small-cap stocks. Large-cap stocks tend to be more stable, while small-cap stocks may offer higher growth potential but come with higher risk.

• Industry – Focus on industries that you believe have strong growth prospects or are currently undervalued.

• Financial Health – Evaluate stocks based on key financial metrics such as revenue growth, profit margins, debt levels, and return on equity (ROE). Look for companies with solid financial performance and strong balance sheets.

Use Stock Screening tools like Screener.in, Moneycontrol, ET Markets, and Investing.com.

Step #2 – Analyze Financial Health

Evaluating Key Financial Metrics

To determine the financial health of a company, it’s essential to analyze various financial metrics.

• Revenue Growth – Consistent revenue growth indicates a company’s ability to increase sales over time. Look for companies with a track record of steady or accelerating revenue growth.

• Earnings Per Share (EPS) – EPS measures a company’s profitability on a per-share basis. A rising EPS trend over time suggests that the company is effectively generating profits for its shareholders.

• Profit Margins – Analyze both the gross profit margin and the net profit margin. High and stable profit margins indicate that a company is managing its costs well and maintaining profitability.

• Return on Equity (ROE) – ROE measures a company’s ability to generate profits from shareholders’ equity. A high ROE indicates efficient use of equity capital.

• Debt Levels – Assess the company’s debt-to-equity ratio to understand its financial leverage. Lower debt levels relative to equity suggest a more financially stable company.

Using Financial Ratios for Analysis

Financial ratios are powerful tools for analyzing a company’s financial health.

• Current Ratio – This liquidity ratio measures a company’s ability to cover its short-term liabilities with its short-term assets. A ratio above 1 indicates good liquidity.

• Quick Ratio – Also known as the acid-test ratio, this ratio excludes inventory from current assets to provide a more stringent measure of liquidity. A ratio above 1 is generally favorable.

• Debt-to-Equity Ratio – This solvency ratio compares a company’s total debt to its shareholders’ equity. A lower ratio indicates lower financial risk.

• Price-to-Earnings (P/E) Ratio – The P/E ratio compares a company’s stock price to its earnings per share. A lower P/E ratio may indicate that the stock is undervalued.

Also Read: Financial Ratios for Fundamental Analysis: P/E, P/B & More

Step #3 – Assess Management and Competitive Position

Strong management is critical for a company’s success.

• Track Record – Look at the historical performance of the company’s management team. Have they successfully led the company through various market conditions?

• Experience – Assess the experience and background of key executives. Management teams with extensive industry experience and a proven track record are more likely to navigate challenges effectively.

• Corporate Governance – Evaluate the company’s corporate governance practices. Strong governance can indicate a management team that operates with transparency and accountability.

• Strategic Vision – Analyze the company’s strategic initiatives and vision for the future. A clear and achievable strategy can be a positive indicator of management’s ability to drive growth.

Understanding a company’s position within its industry is crucial for evaluating its long-term prospects.

• Market Share – Determine the company’s market share within its industry. A leading market position can provide competitive advantages, such as economies of scale and pricing power.

• Competitive Advantages – Identify the company’s unique strengths that give it an edge over competitors. This could include proprietary technology, strong brand recognition, or cost leadership.

• Barriers to Entry – Assess the barriers to entry in the industry. High barriers can protect the company from new competitors, enhancing its competitive position.

• Industry Dynamics – Understand the dynamics of the industry, including growth trends, regulatory environment, and competitive landscape. Companies in growing industries with favorable dynamics are often better positioned for long-term success.

Step #4 – Perform Discounted Cash Flow (DCF) Analysis

Discounted Cash Flow (DCF) analysis is a powerful valuation method used to estimate the intrinsic value of a company based on its expected future cash flows. The goal is to determine whether a stock is undervalued or overvalued compared to its current market price.

Steps to Perform DCF Analysis

1. Project Future Cash Flows –

•  Estimate the company’s future free cash flows (FCF) over a specific period, typically 5-10 years.

•  Free Cash Flow is calculated as –

•  Use historical financial data, industry trends, and management’s guidance to make informed projections.

2. Determine the Terminal Value –

•  The terminal value represents the value of the company’s cash flows beyond the forecast period.

•  It can be estimated using the perpetuity growth model or the exit multiple method.

•  Perpetuity Growth Model Formula –

3. Choose a Discount Rate –

•  The discount rate is used to bring future cash flows to their present value.

•  Typically, the Weighted Average Cost of Capital (WACC) is used as the discount rate.

•  WACC Formula –

4. Calculate the Present Value of Future Cash Flows –

•  Discount the projected free cash flows and the terminal value to their present value using the chosen discount rate.

•  Present Value Formula –

5. Sum the Present Values –

•  Add the present values of all projected cash flows and the terminal value to get the total intrinsic value of the company.

•  Compare this intrinsic value to the company’s current market capitalization to determine if the stock is undervalued or overvalued.

Example of DCF Analysis for an Indian Company

Consider a hypothetical Indian company, XYZ Ltd., with the following projected free cash flows for the next five years –

Year	Projected FCF (₹)
1	10 million
2	12 million
3	14 million
4	16 million
5	18 million

Assume the terminal growth rate is 3% and the WACC is 10%.

• Calculate the Terminal Value –

• Discount the Cash Flows and Terminal Value –

• Calculate the Total Present Value –

Interpretation

If XYZ Ltd.’s current market capitalization is ₹200 million, the intrinsic value of ₹216.52 million suggests that the stock might be undervalued and potentially a good investment opportunity.

Also Read: Understanding Annual Reports – What They Are and How to Read Them?

Step #5 – Compare to Market Value and Make a Decision

Compare Intrinsic Value to Market Value

After performing the Discounted Cash Flow (DCF) analysis and determining the intrinsic value of a stock, the next crucial step is to compare this intrinsic value to the stock’s current market value. This comparison helps investors decide whether to buy, hold, or sell the stock.

1. Calculate Intrinsic Value Per Share –

•  Divide the total present value of future cash flows by the total number of outstanding shares to determine the intrinsic value per share.

2. Compare with Current Market Price –

•  Compare the intrinsic value per share with the stock’s current market price.

•  If the intrinsic value is higher than the market price, the stock might be undervalued and a good buying opportunity.

•  If the intrinsic value is lower than the market price, the stock might be overvalued, suggesting caution or a potential sell.

Decision-Making Criteria

1. Undervalued Stocks –

• Buy – If the intrinsic value is significantly higher than the market price, consider purchasing the stock as it indicates potential for future growth and profit.

• Example – If XYZ Ltd.’s intrinsic value per share is ₹150 and the current market price is ₹100, it might be a good time to buy.

2. Fairly Valued Stocks –

• Hold – If the intrinsic value is close to the market price, the stock is fairly valued. Holding onto the stock could be a reasonable decision if you already own it.

• Example – If XYZ Ltd.’s intrinsic value per share is ₹150 and the current market price is ₹145, holding the stock could be a prudent choice.

3. Overvalued Stocks –

• Sell – If the intrinsic value is lower than the market price, the stock might be overvalued. It might be a good time to sell and realize profits or avoid potential losses.

• Example – If XYZ Ltd.’s intrinsic value per share is ₹150 and the current market price is ₹200, selling the stock could be advisable.

Re-Evaluating Investment Decisions

1. Continuous Monitoring –

•  Regularly monitor the financial health and market performance of the stock.

•  Re-assess the intrinsic value periodically to account for any changes in the company’s financials or market conditions.

2. Diversification –

•  Diversify your investment portfolio to mitigate risks. Don’t rely solely on the DCF analysis of a single stock.

•  Consider other fundamental and technical analysis tools to make well-rounded investment decisions.

Example Scenario

Let’s revisit XYZ Ltd. with the following details –

• Total PV of Future Cash Flows – ₹216.52 million

• Number of Outstanding Shares – 2 million

• Intrinsic Value Per Share –

• Current Market Price – ₹100

Since the intrinsic value per share (₹108.26) is higher than the current market price (₹100), XYZ Ltd. appears to be undervalued, indicating a potential buying opportunity.

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This article is a basic step in understanding stock selection in the Indian stock market. While we aim to provide accurate and up-to-date information, investing in stocks involves significant risks, and there are no guarantees of profit. The value of investments can go up as well as down, and you may not get back the amount you originally invested.

The stocks and brokers mentioned in this article are provided solely for illustrative purposes and should not be construed as recommendations for investment. We do not recommend any specific stocks, brokers, or encourage jumping into stock market investing without thorough research and understanding.

It’s crucial to conduct your own research or consult with a financial advisor to tailor your investment strategy to your individual goals and risk tolerance. Follow the entire series to gain a comprehensive understanding and become a knowledgeable trader or investor. Always remember to invest wisely and consider your financial objectives and risk appetite before engaging in stock market investing.