I’m 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 perpetual stable growth rate. To begin with we have to get estimates of the next five years of cash flows. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
|Levered FCF (₹, Millions)||₹38.47k||₹50.86k||₹45.67k||₹69.49k||₹80.52k|
|Source||Analyst x8||Analyst x11||Analyst x16||Analyst x1||Extrapolated @ (15.87%)|
|Present Value Discounted @ 13.55%||₹33.88k||₹39.45k||₹31.20k||₹41.80k||₹42.66k|
Present Value of 5-year Cash Flow (PVCF)= ₹188.99k
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. 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) = ₹80.52k × (1 + 7.7%) ÷ (13.5% – 7.7%) = ₹1.49m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = ₹1.49m / ( 1 + 13.5%)5 = ₹790.19k
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is ₹979.18k. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of ₹408.11. Compared to the current share price of ₹528.25, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
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 Sun Pharmaceutical Industries 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For SUNPHARMA, I’ve put together three essential aspects you should look at:
- Financial Health: Does SUNPHARMA 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 SUNPHARMA’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 SUNPHARMA? 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.