What is financial modelling?

Hello, I am Umesh Tripathi, and we are learning the concepts of Fundamental Analysis. 
In this video, we are going to discuss various financial modeling tools. 
Among the different Absolute Valuation methods, we will be discussing the DCF (Discounted Cash Flow) method, and we will also be discussing the Dividend Discount Model valuation in detail. 

In the previous videos, we learned that valuation methods are of two types: Absolute Valuation and Relative Valuation. 
So, in this video, we will not be focusing on the Relative Valuation methods. 
We will be discussing only the Absolute Valuation methods, where we will figure out the intrinsic value of a company. 

The intrinsic value is nothing but the actual or fair value of the company, and it helps us compare the current market price of a stock against the intrinsic value. So, for example, if a particular stock’s current price is ₹100 and its intrinsic value comes out to be ₹175, then we should understand that the stock price is trading relatively low compared to its intrinsic value. 
Currently, it is trading at a fairly undervalued price, and according to the concept of the margin of safety, we have a margin of safety here. As we say, price is what you pay, value is what you get, right? 

So, when we are doing Fundamental Analysis in the market, these Absolute Valuation methodologies to identify the intrinsic value become very important for us. In this video, we will discuss two important Absolute Valuation methods: the DCF (Discounted Cash Flow) method, and the second one is the Dividend Discount Model, which focuses on companies that consistently give dividends to their investors. 

The DCF Method 

Let’s first discuss the DCF method of calculating the intrinsic value of a company. 
Here, DCF stands for Discounted Cash Flow, which actually values a company based on the present value of future expected cash flows. In this approach, we estimate what the company’s future cash flows could be, and based on that, we calculate the intrinsic value using the DCF method. 

It is an Absolute Valuation method, which is not based on any comparison with other peer companies, and it tells us how much the company is worth today, given the money it is expected to generate in the future. 

There are certain components and assumptions that we need to consider while doing a DCF analysis. 
Some important components include: 

• Free Cash Flow (FCF) – the forecasted free cash flows in the future. 

• Discount Rate – the WACC (Weighted Average Cost of Capital). 

• Terminal Value – capturing the cash flows beyond the projection period. 

• Intrinsic Value – present value of all cash flows plus present value of the terminal value. 

Growth assumptions need to be made for revenues, margins, free cash flows, and growth rates. 
Risk factors can include market risk or other regulatory risks, which we need to consider while doing a DCF analysis. 

In DCF analysis, we basically consider future free cash flows. 
Here’s an example to clearly understand how we arrive at an intrinsic value using DCF: 

The DCF formula is: 
CF1 / (1 + r)^1 + CF2 / (1+r)^2+....CFn (1+r)^n 
Here, CF1 is the first year’s free cash flow, and r is the discount rate (i.e WACC – Weighted Average Cost of Capital). 
WACC represents the average rate a company expects to pay to finance its assets, considering both debt and equity. 
‘n’ is the number of forecast years. For example, if we want to forecast for 4 years, n will be 4; for 5 years, n will be 5. 

So, we wil calculate the discounted cash flow for 5 years in our example. 

Example assumptions: 

• First year’s free cash flow: ₹100 crore 

• Growth rate of free cash flow: 10% annually for the next 5 years 

• Discount rate: 10% 

• Terminal growth rate after 5 years: 5% 

• Number of outstanding shares: 10 crore shares (for XYZ Ltd.) 

Based on these assumptions, the free cash flow grows annually by 10%. 
By the end of the 5th year, the projected free cash flow will be ₹146.41 crore. 

Applying the discount factor (10%), we calculate the present value of these cash flows. 
For the 5th year’s FCF of ₹146.41 crore, the present value becomes ₹90.94 crore. 

The total present value of the five years’ FCF is ₹450.48 crore. 

Next, we calculate the Terminal Value at the 5th year using the formula: 
Terminal Value = [FCF in final year × (1 + g)] / (r – g) 

Here: 

• FCF in year 5 = ₹146.41 crore 

• g = 5% (growth rate) 

• r = 10% (discount rate) 

So: 
Terminal Value = (146.41 × 1.05) / (0.10 – 0.05) = ₹374.6 crore 

We then discount this Terminal Value to present value: 
Discounted Terminal Value = 374.6 / (1.10^5) = ₹198.2 crore 

Adding all the present values: 
Total intrinsic value of the firm = 450.48 + 198.2 = ₹648.68 crore 

Now, to find the intrinsic value per share, we divide this by the number of outstanding shares (10 crore): 
Intrinsic Value per share = ₹648.68 crore / 10 crore = ₹64.87 

So, if the share price is above ₹64.87, based on this calculation, the valuation is slightly on the higher side. 
If the price is below this level, say ₹50 or ₹40, then compared to the intrinsic value, it would be considered a good valuation and potentially a good investment at the current price. 

The Dividend Discount Model (DDM) 

The Dividend Discount Model is also used to arrive at a company’s intrinsic value, which we can compare to its stock price to decide whether the company is fairly priced or overpriced. 

In DDM, we assume that all future dividends paid by the company are treated as present values, and we calculate intrinsic value based on them. 

The formula is: 
Intrinsic Value = D1 / (r – g) 
Where: 

• D1 = Expected dividend next year 

• r = Required rate of return (discount rate) 

• g = Dividend growth rate 

This model is used for companies that consistently pay dividends and show growth in their dividend payouts. 
For example, if a company has been consistently paying dividends for the past 4 years, we can expect it to continue doing so for the next 4–5 years. 

Example: 
XYZ Ltd. paid a dividend of ₹4 this year. 
Dividends are expected to grow at 5% annually. 
Required rate of return = 10% 

Step 1: Calculate next year’s dividend (D1): 
D1 = D0 × (1 + g) = 4 × (1 + 0.05) = ₹4.20 

Step 2: Calculate intrinsic value: 
Intrinsic Value = 4.20 / (0.10 – 0.05) = ₹84 

So, ₹84 is the intrinsic value derived using the Dividend Discount Model. 
We can compare this with the current stock price to see whether the company is fairly priced, undervalued, or overvalued, and then decide whether to invest at the current price. 

Conclusion 

In this video, we learned that financial modeling tools help us figure out the intrinsic value of a company, so we can compare it against the current stock price. 
Between the two models, DDM is slightly simpler compared to the DCF valuation method. 
However, the limitation of DDM is that it is used only for dividend-paying companies. 

The DCF method is more widely used for arriving at a company’s intrinsic value. 
These models can be very handy for us, but always remember they are not the only tools for making investment decisions. 

Just because the intrinsic value is higher than the current stock price does not automatically mean it is a good investment opportunity qualitative analysis is also important for long-term investment decisions. 

That’s all for this video. 
See you in the next one. 

Investments and securities markets are subject to market risk. Read all the related documents carefully before investing.