Tata Steel Limited's (NSE:TATASTEEL) Intrinsic Value Is Potentially 24% Below Its Share Price

Today we will run through one way of estimating the intrinsic value of Tata Steel Limited (NSE:TATASTEEL) by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Our analysis indicates that TATASTEEL is potentially undervalued!

Is Tata Steel Fairly Valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (₹, Millions)	₹138.5b	₹169.0b	₹181.9b	₹155.0b	₹142.2b	₹136.9b	₹136.1b	₹138.3b	₹142.7b	₹148.8b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x2	Analyst x1	Est @ -8.25%	Est @ -3.74%	Est @ -0.58%	Est @ 1.63%	Est @ 3.18%	Est @ 4.26%
Present Value (₹, Millions) Discounted @ 18%	₹117.8k	₹122.2k	₹111.8k	₹81.0k	₹63.2k	₹51.7k	₹43.7k	₹37.8k	₹33.2k	₹29.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹692b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (6.8%) 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 18%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = ₹149b× (1 + 6.8%) ÷ (18%– 6.8%) = ₹1.5t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹1.5t÷ ( 1 + 18%)¹⁰= ₹290b

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 ₹982b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₹106, the company appears reasonably expensive at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Tata 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 18%, which is based on a levered beta of 1.395. 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.

Looking Ahead:

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. 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. Can we work out why the company is trading at a premium to intrinsic value? For Tata Steel, there are three additional items you should further research:

1. Risks: For example, we've discovered 3 warning signs for Tata Steel (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
2. Future Earnings: How does TATASTEEL'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.