Hindustan Petroleum Corporation Limited (NSE:HINDPETRO) Shares Could Be 32% Above Their Intrinsic Value Estimate

How far off is Hindustan Petroleum Corporation Limited (NSE:HINDPETRO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Hindustan Petroleum

Crunching the numbers

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. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (₹, Millions)	₹20.2b	₹15.8b	₹37.6b	₹40.9b	₹44.1b	₹47.5b	₹51.0b	₹54.7b	₹58.5b	₹62.6b
Growth Rate Estimate Source	Analyst x2	Analyst x3	Analyst x3	Est @ 8.6%	Est @ 8.04%	Est @ 7.65%	Est @ 7.37%	Est @ 7.18%	Est @ 7.04%	Est @ 6.95%
Present Value (₹, Millions) Discounted @ 19%	₹17.0k	₹11.2k	₹22.4k	₹20.4k	₹18.6k	₹16.8k	₹15.2k	₹13.7k	₹12.3k	₹11.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹159b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (6.7%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 19%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = ₹63b× (1 + 6.7%) ÷ (19%– 6.7%) = ₹549b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹549b÷ ( 1 + 19%)¹⁰= ₹97b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹256b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of ₹258, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Hindustan Petroleum 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 19%, which is based on a levered beta of 1.894. 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.

Moving On:

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 company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value lower than the current share price? For Hindustan Petroleum, we've put together three further elements you should explore:

1. Risks: You should be aware of the 2 warning signs for Hindustan Petroleum we've uncovered before considering an investment in the company.
2. Future Earnings: How does HINDPETRO's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. 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!

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.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.