Are Investors Undervaluing Solara Active Pharma Sciences Limited (NSE:SOLARA) By 22%?

Does the August share price for Solara Active Pharma Sciences Limited (NSE:SOLARA) reflect what it's really worth? Today, we will estimate the stock's intrinsic value 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. 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.

View our latest analysis for Solara Active Pharma Sciences

The Model

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 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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (₹, Millions)	₹2.87b	₹2.02b	₹1.60b	₹1.41b	₹1.31b	₹1.28b	₹1.28b	₹1.31b	₹1.36b	₹1.42b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ -20.47%	Est @ -12.31%	Est @ -6.59%	Est @ -2.59%	Est @ 0.21%	Est @ 2.17%	Est @ 3.55%	Est @ 4.51%
Present Value (₹, Millions) Discounted @ 12%	₹2.6k	₹1.6k	₹1.1k	₹886	₹737	₹640	₹571	₹520	₹480	₹447

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹9.6b

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)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = ₹1.4b× (1 + 6.8%) ÷ (12%– 6.8%) = ₹28b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹28b÷ ( 1 + 12%)¹⁰= ₹8.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹18b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₹393, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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 0.857. 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.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 discount to intrinsic value? For Solara Active Pharma Sciences, we've compiled three fundamental factors you should explore:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Solara Active Pharma Sciences .
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SOLARA's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.