Today we will run through one way of estimating the intrinsic value of Morepen Laboratories Limited (NSE:MOREPENLAB) by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.
Is Morepen Laboratories fairly valued?
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company’s last reported value. We assume companies with shrinking free cash flow are 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
|Levered FCF (₹, Millions)||₹538||₹595||₹651||₹710||₹770||₹834||₹901||₹972||₹1.0k||₹1.1k|
|Growth Rate Estimate Source||Est @ 11.66%||Est @ 10.43%||Est @ 9.56%||Est @ 8.96%||Est @ 8.54%||Est @ 8.24%||Est @ 8.03%||Est @ 7.89%||Est @ 7.79%||Est @ 7.72%|
|Present Value (₹, Millions) Discounted @ 15.13%||₹468||₹449||₹427||₹404||₹381||₹358||₹336||₹315||₹295||₹276|
Present Value of 10-year Cash Flow (PVCF)= ₹3.71b
“Est” = FCF growth rate estimated by Simply Wall St
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 10-year government bond rate (7.6%) 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 15.1%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = ₹1.1b × (1 + 7.6%) ÷ (15.1% – 7.6%) = ₹16b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = ₹₹16b ÷ ( 1 + 15.1%)10 = ₹3.91b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹7.62b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of ₹16.98. Compared to the current share price of ₹17.65, the company appears around fair value at the time of writing. The assumptions in a DCF have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own assumptions. 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 Morepen Laboratories 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 15.1%, which is based on a levered beta of 0.882. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Morepen Laboratories, I’ve put together three essential aspects you should further examine:
- Financial Health: Does MOREPENLAB 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of MOREPENLAB? 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 NSE every day. If you want to find the calculation for other stocks just search here.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.