A Look At Discounted Cashflow Valuation

This model, based upon expected cashflows and discount rates, is appropriate for companies in mature industries

In general, there are two approaches to valuation. The first, discounted cashflow valuation (DCF), relates the value of an asset to the present value of expected future cashflows on that asset. The second, relative valuation, tries to determine the under or over-valuation of an asset when compared with its peers in terms of common variables like earnings, cashflows, book value or sales.

We will discuss the DCF approach.

The basis of this model is that the value of an asset is equal to the present value of its expected future cashflows. In other words, you discount the expected future cashflows back to today's dollar at a certain rate.

The cashflow will vary from asset to asset - dividends for stocks, coupons (or interest) and the par value for bonds, and after-tax cashflows for a real investment project.

As for the rate used to discount the cashflows, it will depend on the riskiness of the cashflows. If the certainty of receiving the cashflows is low, which means the asset is more risky, then a

higher rate will be used. The higher the discount rate, the lower the present value of the cashflows.

To discount next year's cashflow to the present value (PV), you divide the expected cashflow to be received next year by one plus the discount rate in decimal form. For PV of cashflow to be received two years later, you divide the sum by the square of one plus the discount rate. The PVs of cashflows in year three, four, five and so on are arrived at by dividing the cashflows with one plus the discount rate to the power of three, four, five and so on, respectively.

So theoretically, to get the value of an asset, you have to project its future cashflows until the end of its life, discount the cashflow streams using their respective discount factors, and sum up the present value of the cashflows.

This can be a tedious process. A special form of the formula is called the constant growth model. To use this model, it is assumed that the cashflows will grow at a constant rate in perpetuity.

Take, for example, SMRT. The shares paid 2.15 cents after-tax dividend last year. Assume, also, that SMRT increases its dividend payment by 2 per cent a year in perpetuity. The 2 per cent growth is arrived at after taking into consideration the average growth of Singapore residents of 1.7 per cent in the last 10 years and allowing room for fare hikes and also SMRT's need for maintenance and capital expenditure.

Since SMRT has a fairly stable income, you may decide that you need to have 6 per cent return in order to compensate you for taking on the risk of holding the stock.

The stock's value is then: Next year's dividend/(your required rate of return - the growth rate in dividends forever).

So, in the above example, your next year's dividend is 2.237 cents, your required rate of return is 6 per cent and the constant growth rate is 2 per cent. Plugging the numbers into the formula and you get $0.02237/0.04 or $0.559. This compares with SMRT's last traded price of $0.575 a share.

But if you think the company is not as risky and you need only 5 per cent return to entice you to hold the stock, then the stock's value is $0.02237/(.05-.02) or $0.746.

Or if you think that SMRT will increase its dividend by 3 per cent a year instead of 2 per cent, and at the required rate of return of 5 per cent, then SMRT's value will be $1.12 a share.

As can be seen, a small change in assumptions can have a significant impact on the derived value of SMRT. In short, the higher the required rate of return you need, the lower the value of the stock. On the other hand, the higher the growth rate, the higher the value of the stock.

This model is appropriate for companies in mature industries whose sustainable growth rate approximates the long-run growth of the economy.