Today we'll do a simple run through of a valuation method used to estimate the attractiveness of IFB Industries Limited (NSE:IFBIND) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Step by step through the calculation
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
|Levered FCF (₹, Millions)||₹3.24b||₹3.65b||₹4.04b||₹4.42b||₹4.81b||₹5.20b||₹5.61b||₹6.03b||₹6.47b||₹6.93b|
|Growth Rate Estimate Source||Est @ 14.76%||Est @ 12.38%||Est @ 10.72%||Est @ 9.56%||Est @ 8.74%||Est @ 8.17%||Est @ 7.77%||Est @ 7.49%||Est @ 7.3%||Est @ 7.16%|
|Present Value (₹, Millions) Discounted @ 15%||₹2.8k||₹2.7k||₹2.6k||₹2.5k||₹2.4k||₹2.2k||₹2.1k||₹1.9k||₹1.8k||₹1.7k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹23b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 6.8%. We discount the terminal cash flows to today's value at a cost of equity of 15%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₹6.9b× (1 + 6.8%) ÷ (15%– 6.8%) = ₹87b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹87b÷ ( 1 + 15%)10= ₹21b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹44b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of ₹1.1k, the company appears about fair value at a 0.5% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at IFB Industries 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 accounts for debt. In this calculation we've used 15%, which is based on a levered beta of 1.240. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For IFB Industries, we've compiled three relevant elements you should further research:
- Risks: For example, we've discovered 2 warning signs for IFB Industries that you should be aware of before investing here.
- Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
- Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!
PS. Simply Wall St updates its DCF calculation for every Indian stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you’re looking to trade IFB Industries, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.