A Look At The Fair Value Of Solara Active Pharma Sciences Limited (NSE:SOLARA)

How far off is Solara Active Pharma Sciences Limited (NSE:SOLARA) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

View our latest analysis for Solara Active Pharma Sciences

Crunching the numbers

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (₹, Millions)	-₹747.5m	₹3.50b	₹3.32b	₹3.28b	₹3.31b	₹3.40b	₹3.54b	₹3.71b	₹3.91b	₹4.13b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Est @ -1.33%	Est @ 1.09%	Est @ 2.79%	Est @ 3.97%	Est @ 4.8%	Est @ 5.38%	Est @ 5.79%
Present Value (₹, Millions) Discounted @ 12%	-₹669	₹2.8k	₹2.4k	₹2.1k	₹1.9k	₹1.7k	₹1.6k	₹1.5k	₹1.4k	₹1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹16b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 5-year average of the 10-year government bond yield (6.7%) 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 12%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = ₹4.1b× (1 + 6.7%) ÷ (12%– 6.7%) = ₹89b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹89b÷ ( 1 + 12%)¹⁰= ₹29b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹45b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₹1.0k, the company appears about fair value at a 19% discount to where the stock price trades currently. The assumptions in any calculation 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.

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. 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 Solara Active Pharma Sciences 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 0.800. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Solara Active Pharma Sciences, there are three pertinent factors you should look at:

1. Risks: For example, we've discovered 4 warning signs for Solara Active Pharma Sciences (2 are concerning!) that you should be aware of before investing here.
2. Future Earnings: How does SOLARA'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. 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. 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.