Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Cipla Limited (NSE:CIPLA) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today’s value. I will use the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not August 2018 then I highly recommend you check out the latest calculation for Cipla by following the link below.
See our latest analysis for Cipla
The model
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF (₹, Millions) | ₹14.47k | ₹16.70k | ₹20.09k | ₹32.07k | ₹35.67k |
| Source | Analyst x10 | Analyst x11 | Analyst x11 | Analyst x1 | Est @ 11.22% |
| Present Value Discounted @ 13.55% | ₹12.74k | ₹12.95k | ₹13.72k | ₹19.30k | ₹18.90k |
Present Value of 5-year Cash Flow (PVCF)= ₹77.61b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (7.7%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 13.5%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = ₹35.67b × (1 + 7.7%) ÷ (13.5% – 7.7%) = ₹660.75b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = ₹660.75b ÷ ( 1 + 13.5%)5 = ₹350.09b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is ₹427.70b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of ₹531.16. Compared to the current share price of ₹629.45, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
The assumptions
I’d like to 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Cipla as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 13.5%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For CIPLA, I’ve compiled three essential aspects you should further examine:
- Financial Health: Does CIPLA have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does CIPLA’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of CIPLA? 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 for every stock on the NSE every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.