Hydrix Ltd (FRA:STJ) DCF Valuation

GuruFocus DCF Calculator FAQs

What is DCF modeling?

In a discounted cash flow model, the future cash flows are first estimated based on a cash flow growth rate and a discount rate and then, discounted to its current value at the discount rate. All of the discounted future cash flow is added together to get the current intrinsic value of the company.

Usually, a two-stage model is used when calculating a stock's intrinsic value using a discounted cash flow model. The first stage is called the growth stage; the second is called the terminal stage. In the growth stage the company grows at a faster rate. Because it cannot grow at that rate forever, a lower rate is used for the terminal stage.

GuruFocus DCF calculator is actually a Discounted Earnings calculator, the Earnings Per Share without NRI is used as the default. The reason we are doing this is we found that historically stock prices are more correlated with earnings than free cash flow.

What are DCF models used for?

Compared with the valuation ratios such as P/E, P/S, P/B etc, DCF model is able to include both balance sheet value, future business earnings and earning growth. The factors that affect the value of business in the DCF model are: book value, current free cash flow, business growth rate, and terminal value.

Just as pointed by Joe Ponzio, it only makes sense to calculate the intrinsic value for the companies that have predictable earnings. We will apply this to predictable companies only.

How do you calculate DCF?

The intrinsic value of a business can be calculated with this equation:
Intrinsic Value = Future Earnings at Growth Stage + Terminal Value
= E(0) * x * (1 - xⁿ) / (1 - x) + E(0) * xⁿ * y * (1 - y^m) / (1 - y)
where x = (1 + g1) / (1 + d), and y = (1 + g2) / (1 + d)

Parameters:
E(0) – current earnings : GuruFocus default to use EPS without NRI as the input. You can switch to FCF and see the intrinsic value based on Free Cash Flow per Share.
d – discount rate : A reasonable discount rate assumption should be at least the long term average return of the stock market, which can be estimated from risk free rate plus risk premium of stock market. We used the 10-Year Treasury Constant Maturity Rate as the risk free rate and rounded up to the nearest integer, then added a risk premium of 6% to get the estimated discount rate. Some investors use their expected rate of return, which is also reasonable. A typical discount rate can be anywhere between 6% - 20%.
g1 – growth rate at growth stage : Growth Rate in the growth stage = average earning / free cash flow growth rate in the past 10 years. If it is higher than 20%, GuruFocus uses 20%. If it is less than 5%, GuruFocus uses 5% instead.
g2 – growth rate at terminal stage : Default to use 4%. After the growth stage, it is more reasonable to set the terminal growth rate at the inflation rate. The terminal growth rate must be smaller than the discount rate to make the calculation converge.
n – number of years at the growth stage : Default to use 10 years.
m – number of years at the terminal stage : Default to use 10 years.

Which cash flow is used in DCF?

GuruFocus’ research has found that GAAP earnings per share produces a stronger correlation between intrinsic value and margin of safety than free cash flow does. Thus, GuruFocus’ DCF Calculator uses earnings per share by default although users can switch the calculation to free cash flow or dividends or use a customized base-year value.

How long do you project a DCF?

Most DCF models use either five or 10 years of cash flow estimates. By default, GuruFocus projects the cash flows using two 10-year periods: a growth stage at the 10-year earnings growth rate followed by a terminal stage using 4% growth over 10 years. GuruFocus sets two growth factors: x for the growth stage and y for the terminal stage. x = (1 + growth rate at growth state) / (1 + discount rate) while y = (1 + growth rate at terminal stage) / (1 + discount rate).

What is the growth-stage growth rate?

A reasonable growth-stage growth rate is the average earnings or free cash flow growth rate over the past 10 years. However, since we do not know how the business will grow in the future, there is a big assumption in the DCF model for the future business growth rate. This is why business predictability is important. It only makes sense to apply DCF models if the business has been growing consistently. Only for consistently growing business, it is more reasonable to assume it will be growing in the same manner for the coming years.

Further, to account for abnormal growth situations, including fast growers and stocks that do not have enough data to compute a growth rate, GuruFocus caps the growth-stage growth rate between 5% and 20%.

What is a good terminal growth rate?

Obviously no business can grow forever. At some point the growth will slow down. But the business still has its value as long as it is still generating cash for its owners. Further, while the contribution from each of the far future years is small, they do add up.
GuruFocus has set a default of 10 to the number of years that the company will grow at the terminal growth rate. After the terminal growth years the contribution will be cut to 0.

Terminal value = E(0) * xⁿ * y * (1 - y^m) / (1 - y), where y = (1 + g2) / (1 + d), where m is the years of terminal growth; g2 is the terminal growth rate.
Terminal growth rate also affects the result of the DCF model. It is more reasonable to assume terminal rate at around long term inflation rate or less. To make the above equation converge, it is important to assume that the terminal rate is smaller than the discount rate.

What is a discount rate in DCF?

Discount rate is another big assumption that can severely affect the value obtained from the DCF model. A reasonable discount rate assumption should be at least the long term average return of the stock market, which is about 11%, because investors can always invest passively in an index fund and get an average return. Some investors use their expected rate of return, which is also reasonable. A typical discount rate can be anywhere between 10% - 20%.

GuruFocus takes the 10-year Treasury constant maturity rate, rounds it up to the nearest whole integer, and then adds a 6% equity risk premium.

What is free cash flow?

Free Cash Flow is very close to Warren Buffett's definition of Owner's Earnings, except that in Warren Buffett's Owner's Earnings, the spending for Property, Plant, and Equipment is only for maintenance (replacement), while in the Free Cash Flow calculation, the cost of new Property, Plant, and Equipment due to business expansion is also deducted. There, Free Cash Flow is more conservative than Owner's Earnings.

In Don Yacktman's calculation of forward rate of return, he uses Free Cash Flow for the calculation. Yacktman explained the forward rate of return concept in detail in his interview with GuruFocus. Yacktman defines forward rate of return as the normalized free cash flow yield plus real growth plus inflation.

What is tangible book value?

When you buy a company’s stock, you become a fractional owner of the business. If the company is liquidated after you buy, you are entitled to what the company owns net of its debt. This part is called shareholder’s equity.

Shareholder’s equity is certainly a part of business value. However, shareholder’s equity may overestimate or underestimate its real value. The recent accounting rule of mark-to-market may change this, but we all know that the market is not always efficient. (That is why we are here investing as value investors.) The book value of stocks may still deviate its underlying values.

Several companies have an item called goodwill, which may come from the past acquisitions of the company. This part may not be worth anything at the time of liquidation. Therefore, we use tangible book value rather than standard book value for the book value calculation.

GuruFocus’ DCF Calculator allows you to add tangible book value to the fair value calculation. Also, if you want to add a perpetuity terminal value to fair value, you can do so using this cell.

How do you value a company using DCF?

GuruFocus users can quickly calculate the DCF using the DCF Calculator. Simply enter a stock ticker in the “Ticker” cell and the parameters will be filled with the default values. Users can also change the parameters and save DCF parameter templates by clicking on the “Save Parameters” button.

How do I get DCF value in Excel?

You can also download the GURUF DCF Calculator template for both Excel Add-in and Google Sheets and then use the following functions.

=GURUF("AAPL","Intrinsic Value: DCF (Earnings Based)")
=GURUF("AAPL","Intrinsic Value: DCF (FCF Based)")

When should you not use DCF?

GuruFocus does not record in the database DCF intrinsic value for stocks with unpredictable revenue or earnings (business predictability rank of one-star or unranked). Since the model projects future growth, it is assumed that the company will grow at the same rate as it did over the past 10 years. Therefore, the model works better for companies that have consistent earnings performance.