Discounted Cash Flow

Discounted cash flow (DCF) valuation is used to evaluate the investment-worthiness of a stock. If the value derived
from DCF valuation is higher than the current market price, the opportunity might be worth considering.
Discounted Cash Flow valuation uses future free cash flow streams and discounts them (using a risk free rate +
risk premium) to arrive at the present value.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book - The 5 Rules for Successful Stock
Investing - tells us about discounted cash flows (DCF) how we can go about calculating them.

What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than
60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.

Companies create economic value by investing capital and generating a return. Some of that return pays operating
expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free
cash flow because that's the amount of money that could be taken out of the business each year without harming
its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend,
which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which
reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or,
the firm can retain the free cash flow and re-invest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those
future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we
receive today.

Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to
generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time
value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be
compensated for that risk, called the risk premium.

The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it
today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the
government will be around to pay us our interest in a few years.

Of course, not many cash flows are as certain as those from the government, so we need to take an additional
premium to compensate us for the risk that we may never receive the money we have been promised. Add the
government bond rate to the risk premium, and we have what's known as a discount rate.

Now you can start to see why stocks with stable, predictable earnings often have such high valuations - investors
discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the
likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain
future should logically have a lower valuation because there is a substantial risk that the potential future cash flows
will never materialise.

You can see why a rational investor should be willing to pay more for a company that's profitable now relative to
one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and
thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing
their value still further.

Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three
examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.
However, the value of the discounted cash flows is quite different from company to company. In present value
terms, CycliCorp is worth about $2700 less than StableCorp. That's because StableCorp is more predictable, which
means that investors' discount rate isn't high. CycliCorp's cash flow increases by 20 percent some years and
shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they
are valuing its shares. As a result the present value of the discounted cash flows is lower.

The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth
almost $8300 less than StableCorp. Not only are the bulk of RiskCorp's cash flows far off in the future, bu also, we
are less certain that they will come to pass, so we assign an even higher discount rate.

This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and
riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when
deciding how much to pay for a stock. That's all it really boils down to. 

Opto Circuits India Ltd. -Stock Valuation (16 Dec

2008)
For a firm with an above-average economic moat as Opto Circuits, valuation is likely to be the Achilles' heel in the
investment analysis process. Companies like this are rarely cheap, so we need to tread carefully as we decide what
a reasonable value would be for Opto's shares. Even though the firm's high growth rate and strong profitability
mean that we should be willing to pay up for the shares, we can't pay too much, or we will be unlikely to receive a
decent return on our investment.

Opto Circuits Historical Valuation

Comparing a stock’s current ratios with its historical ratios can be useful, especially for stable firms that haven’t
undergone major shifts in their business. If you see a solid company that’s growing at roughly the same rate with
roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you
should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed,
in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an
irrationally low level.

Opto Circuits Current Valuation

The easiest way to using a P/E ratio is to compare it to a benchmark, such as another company in the same
industry, the entire market, the industry average, or the same company at a different point in time. Each of these
approaches has some value, as long as you know the limitations.

A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even
firms in the same industry can have very different capital structures, risk levels and growth rates, all of which
effect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less
debt, and has lower capital re-investment needs.

Starting with the basic valuation multiples, we find that Opto is trading at about 12 times the past year's earnings,
as of this writing. That's pricey - it's much above the firm's average P/E of ~ 9 over the past 5 years. On a trailing
twelve months (TTM) basis, it is trading at ~11.4 times standalone earnings.

Price to Sales, and Price to Book ratios indicate that the stock is trading at slightly higher than its historic average
levels, though on a Price to Cash flow basis the stock seems to be available cheaper than its historical averages.
  

Opto's earnings yield of ~14% and dividend yield of 5.29% point towards Opto Circuits providing decent returns to
its shareholders as compared to investments say in risk-free GOI deposits (8% currently). Given Opto's higher risk
than a treasury deposit, the high dividend yield and earnings yield from its shares seems to point to decent
returns. Besides a not insignificant Cash return of ~3% is also an encouraging factor. Essentially cash return tells
you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole
company, including the debt burden.

Dividend Sustainability
What about sustainability of dividends? Perhaps a look at historical dividend paying record of Opto can provide
some pointers to that.
  

That’s a pretty impressive dividend payment record. It has increased dividend per share gradually over the years,
every year. Dividends over last 5 yrs have grown at a CAGR of ~11% which is a decent record. Dividend payouts
(DPS/EPS) have been maintained at roughly 33-36% which is again a decent record. If Opto continues to grow
decently, it seems the dividend record will be sustained.

Recent evidence of Insider Buying?

Recent evidence of insider buying/selling can provide some pointers for what the management feels about the
stocks current valuation. Sustained buying may indicate that in the management’s eyes the stock may be
undervalued.
Warrant Conversion
Update Jan 15, 2009

Opto Circuits promoter shareholding was 30.50% as of Dec 31 2008. On January 12th 2009 another 5,40,000
warrants were converted to an equal no. of shares and alloted to Mr.Vinod Ramnani, CMD and Promoter - Director,
OCI at Rs.360 per share -adjusting for the two intervening bonuses in Oct 2007 & Nov 2008 -at ~Rs.140 a share,
or a 55 percent premium over Rs.90 -closing market price on Jan 12, 2009.

Why would promoters pay such a hefty premium? Was the company in need of urgent infusion of funds? Or, is this
just another indication that the stock may be undervalued -in the eyes of the promoters?

Update 25 Mar 2009

Excerpt from Interview with Mr. Vinod Ramnani, MD Opto Circuits.

Mr. Ramnani, would you clarify why you chose to convert 5.4 lakh warrants at such a high premium.
Our estimates show you could have picked up at Rs. 70 from the market

"Unlike how many people think, this was a no-brainer for me. From a principled standpoint, I wanted to honour the
commitment. Had the market boomed at the time of warrant conversion, I stood to gain significantly. Why should
it be different in the reverse case. The money would accrue to the company if I convert, but would go away to
some 3rd party if I bought from the open market.

But be assured it made perfect sense from a financial standpoint as well. Purchasing such huge numbers from the
market couldn't be done at prices you mentioned. The whole transaction would have taken prices to significantly
higher levels. And don't forget the 10% paid on allotment would have been forfeited. So do you think you would do
otherwise for some small gain of Rs. 20-30??"

Check out the 10 questions put to Opto Circuits Management and read the full 2-part Management Interview. 

Finally let’s attempt a discounted cash flow analysis for Opto Circuits to try and guage its Intrinsic Value.

Opto Circuits Intrinsic Value modeling

Opto has been generating free cash as percentage of sales at around 4-6% over the years with the occasional dip
as in FY 07. That it has been managing this despite investing aggressively in business expansion, goes to its credit.

Opto's long term sales growth stands at over 45% and long term earnings growth at over 60%. The 3yr
averages are even more impressive at almost 60% sales growth and over 78% EPS growth. Given the above (and
the medium term sustainability of its growth ), if we estimate that Opto will grow sales at 40% for FY09 and the
Criticare Systems contribution (1HFY09 sales $20Mn, acquired April 2008) will add another Rs.100 Cr. to the
topline, that will mean Rs. 755 Cr sales for FY09. Taking 5% of sales as Free Cash flow generation for FY09,that
stands at ~ Rs. 37 Cr. Opto Circuits increasing free cash flow at 20% over FY 08 (Rs.28.96 Cr.), would also imply
similar levels of free cash flow for FY09 ~Rs. 34.75 Cr.

Let us also assume that Opto Circuits increases free cash flow at the rate of 20% annually for the next 5 years,
slowing to about 15% in yrs 6-10, it will generate about Rs. 817 Cr in free cash flow over the next decade.
Discounted back to the present at 13%, the Present Value is about Rs. 380 Cr. Add in Opto circuits'
discounted Perpetuity Value of Rs. 560 Cr, and Opto Circuits is worth about Rs.940 Cr, or about Rs. 100 per share
is itsIntrinsic Value.

We used a relatively low discount rate of 13% -versus a market average of 15%- because Opto Circuits enjoys
an above-average economic moatand has a great track record of profitability, strong financial health, and operates
from a relatively strong competitive position within the medical electronics industry.

Unfortunately, there is no precise way to calculate the exact discount rate that one should use in discounted cash
flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to
estimate discount rates. Here's what we want to know for practical purposes. As interest rates rise, so will discount
rates. As a firm's risk level increases, so will its discount rate. Putting these two together, we derive the discount
rate. We use 15 percent as the discount rate for an average company based on the several factors that are taken
into account while estimating discount rates and create a distribution of discount rates based on whether firms are
riskier or less risky than the average.
Price levels to get interested in Opto Circuits
How large should your margin of safety, be? It ranges all the way from just 20 percent for very stable firms with
wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms
we would require a 25 percent margin of safety, while on average we require a 30 percent to 40 percent margin of
safety for most firms.

The set of assumptions as above, results in an estimated intrinsic value per share of about Rs. 100 for Opto
Circuits, which is right around where the shares are trading as of this writing. If I assume this to be a reasonable
scenario, I would start getting interested in the stock at around Rs. 75, which would be a 25 percent discount to
our estimated intrinsic value.

We are not looking for much of a margin of safety because of Opto Circuits' strong balance sheet, excellent
industry prospects, and solid profitability all make it less likely that something will go horribly wrong with the
assumptions.

For us to believe that Opto Circuits' shares are worth Rs. 100, we have to believe that it can hold off competition
and continue to grow at an above-average rate for a long period of time. Companies that can increase free cash
flow at an average rate of 17-18% for a decade -which is what our scenario assumes- are few and far between,
after all.

Having thought of possible scenarios for Opto Circuits, we now know exactly what assumptions are incorporated in
our estimated intrinsic value of Rs.100 per share. Armed with that knowledge, we can make a more informed
investment decision - we probably wouldn't know as much about the assumptions needed to believe that the stock
is reasonably valued, if we had just looked at the current P/E relative to the historical average P/E, or other such
benchmarks.

This brings us to the end of Opto Circuits valuation exercise