Stock Analysis

A Look At The Intrinsic Value Of JSW Steel Limited (NSE:JSWSTEEL)

NSEI:JSWSTEEL
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of JSW Steel Limited (NSE:JSWSTEEL) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for JSW Steel

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. To begin with, we have to get estimates of 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (₹, Millions) ₹86.8b ₹104.3b ₹128.8b ₹149.0b ₹168.3b ₹187.0b ₹205.4b ₹223.8b ₹242.4b ₹261.5b
Growth Rate Estimate Source Analyst x13 Analyst x14 Analyst x5 Est @ 15.61% Est @ 12.98% Est @ 11.14% Est @ 9.85% Est @ 8.95% Est @ 8.31% Est @ 7.87%
Present Value (₹, Millions) Discounted @ 15% ₹75.4k ₹78.6k ₹84.4k ₹84.7k ₹83.1k ₹80.2k ₹76.5k ₹72.4k ₹68.1k ₹63.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹767b

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)= FCF2031 × (1 + g) ÷ (r – g) = ₹262b× (1 + 6.8%) ÷ (15%– 6.8%) = ₹3.4t

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹3.4t÷ ( 1 + 15%)10= ₹820b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is ₹1.6t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of ₹722, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NSEI:JSWSTEEL Discounted Cash Flow July 29th 2021

Important assumptions

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. 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 JSW Steel 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 1.214. 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.

Next Steps:

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. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For JSW Steel, we've put together three relevant aspects you should look at:

  1. Risks: Every company has them, and we've spotted 3 warning signs for JSW Steel (of which 1 is concerning!) you should know about.
  2. Future Earnings: How does JSWSTEEL'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NSEI every day. If you want to find the calculation for other stocks just search here.

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