Does the June share price for ISMT Limited (NSE: ISMTLTD) reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by projecting its future cash flows, then discounting them to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
Keep in mind, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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What is the estimated valuation?
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (₹, Millions)||561.2m||607.9m||655.8m||₹ 705.4m||757.2m||811.7m||869.3m||930.2m||995.0m||₹ 1.06b|
|Source of estimated growth rate||Est @ 8.95%||Est @ 8.32%||Est @ 7.87%||East @ 7.56%||Est @ 7.35%||Est @ 7.19%||Est @ 7.09%||Est @ 7.01%||Est @ 6.96%||Is 6.93%|
|Present value (₹, Millions) discounted @ 21%||₹ 466||₹ 418||₹ 374||₹ 334||₹ 298||265||₹ 235||209||185||164|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 2.9b
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (6.8%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 21%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₹ 1.1b × (1 + 6.8%) ÷ (21% – 6.8%) = ₹ 8.3b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹ 8.3b ÷ (1 + 21%)ten= 1.3b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is ₹ 4.2b. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of 23.2, the company appears to be roughly at fair value with a 20% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view ISMT as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes into account debt. In this calculation, we used 21%, which is based on a leveraged beta of 2,000. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For the ISMT, there are three relevant factors you should explore:
- Risks: Every company has them, and we have spotted 3 warning signs for ISMT (1 of which is a bit disturbing!) that you should know about.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what else you might be missing!
- Other environmentally friendly companies: Are you concerned about the environment and think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover stocks you may not have thought of!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NSEI share. If you want to find the calculation for other actions, do a search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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