Today we'll do a simple run through of a valuation method used to estimate the attractiveness of UltraTech Cement Limited (NSE:ULTRACEMCO) as an investment opportunity by estimating the company's 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.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching the numbers
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. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (₹, Millions)||₹63.7b||₹88.1b||₹98.8b||₹108.1b||₹117.4b||₹126.9b||₹136.7b||₹146.9b||₹157.6b||₹168.9b|
|Growth Rate Estimate Source||Analyst x17||Analyst x17||Analyst x8||Est @ 9.41%||Est @ 8.64%||Est @ 8.1%||Est @ 7.72%||Est @ 7.46%||Est @ 7.27%||Est @ 7.14%|
|Present Value (₹, Millions) Discounted @ 12%||₹56.7k||₹69.8k||₹69.6k||₹67.8k||₹65.5k||₹63.1k||₹60.5k||₹57.8k||₹55.2k||₹52.6k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹619b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 12%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹169b× (1 + 6.8%) ÷ (12%– 6.8%) = ₹3.3t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹3.3t÷ ( 1 + 12%)10= ₹1.0t
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. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of ₹7.5k, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 UltraTech Cement 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 12%, which is based on a levered beta of 0.807. 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.
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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For UltraTech Cement, we've put together three essential aspects you should further research:
- Risks: We feel that you should assess the 2 warning signs for UltraTech Cement we've flagged before making an investment in the company.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ULTRACEMCO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. 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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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.
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