Investment Valuation in India

The Discount Rate is a general term referring to any rate that is used in finding the present value of a future cash flow. it reflects the return or compensation required by an investor for a) delaying consumption (represented by the risk free rate) and b) assuming risk of cash flow Different discount rates may be used for different expected future cash flows. This is possible due to varying rates of inflation and other factors that may affect the future cash flows. However, for simplicity, generally a single discount rate (required rate of return) is used in most cases to discount future cash flows to appear at the present value of future cash flows.

One of the methods of valuing a company based on Discounted Cash Flow Method is as follows: Value of the Company = Free Cash Flow for the Firm (FCFF) for next year / (Cost of Capital - Growth Rate) where: FCFF = EBIT next year x (1 - Tax Rate) x (1 - Reinvestment Rate) Cost of Capital is the Weighted Average Cost of Capital (WACC) i.e. Weight of Debt (Wd) x Cost of Debt (Kd) + Weight of Equity (We) x Cost of Equity (Ke) Reinvestment Rate represents the amount required to be invested in the company every year to keep the company looking good and working well, even if the company does not grow in size. Reinvestment Rate is calculated as Expected Growth rate (g) / Cost of Capital (Kc) Note this is a simplistic method of calculation and is just one of the many ways of calculating value of a company. The method assumes that the company is growing at a constant growth rate which may not be a fair assumption to make, especially in case of start-ups or companies underg...

We now begin the discussion of the discounted cash flows valuation model . Cash flows to equity are cash flows after debt payments and that cash flows to firm are cash flows before debt payments. When valuing a company using cash flows to firm, one needs to use the cost of capital when discounting the cash flows and then you need to subtract out debt . The most important part of this discussion is to pick an approach and stick with it. Don’t mix and match. I must admit that in the past I’ve gotten confused and probably mixed and match components of valuing stocks by discounting cash flows to equity and valuing stocks by discounting cash flows to firm. There are three main mistakes that you need to watch out for, which include: Discounting cash flows to equity at the cost of capital to get equity value Discounting cash flows to firm at cost of equity to get firm value Discounting cash flows to firm at cost of equity, forget to subtract out debt, and get too high a value for equity Make ...