Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of 3i Infotech Limited (NSE:3IINFOTECH) as an investment opportunity 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!
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. 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.
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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
|Levered FCF (₹, Millions)||₹1.1k||₹1.2k||₹1.3k||₹1.4k||₹1.5k||₹1.6k||₹1.8k||₹1.9k||₹2.0k||₹2.2k|
|Growth Rate Estimate Source||Est @ 10.71%||Est @ 9.76%||Est @ 9.1%||Est @ 8.63%||Est @ 8.31%||Est @ 8.08%||Est @ 7.92%||Est @ 7.81%||Est @ 7.73%||Est @ 7.68%|
|Present Value (₹, Millions) Discounted @ 23.06%||₹869||₹775||₹687||₹607||₹534||₹469||₹411||₹360||₹315||₹276|
Present Value of 10-year Cash Flow (PVCF)= ₹5.30b
“Est” = FCF growth rate estimated by Simply Wall St
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 7.6%. We discount the terminal cash flows to today’s value at a cost of equity of 23.1%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = ₹2.2b × (1 + 7.6%) ÷ (23.1% – 7.6%) = ₹15b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = ₹₹15b ÷ ( 1 + 23.1%)10 = ₹1.91b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹7.22b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of ₹4.45. Relative to the current share price of ₹3.75, the company appears about fair value at a 16% discount to what it is available for right now. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
Now 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 these result, have a go at the calculation yourself and play with the 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 3i Infotech 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 23.1%, which is based on a levered beta of 1.804. 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 3i Infotech, There are three additional aspects you should further research:
- Financial Health: Does 3IINFOTECH 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 3IINFOTECH? 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.