Does the March share price for Firstsource Solutions Limited (NSE:FSL) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by estimating the company’s future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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 are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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
|Levered FCF (₹, Millions)||₹3.55b||₹4.52b||₹5.02b||₹5.44b||₹5.86b||₹6.29b||₹6.73b||₹7.20b||₹7.68b||₹8.20b|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Analyst x3||Est @ 8.25%||Est @ 7.72%||Est @ 7.35%||Est @ 7.09%||Est @ 6.9%||Est @ 6.78%||Est @ 6.69%|
|Present Value (₹, Millions) Discounted @ 15%||₹3.1k||₹3.4k||₹3.3k||₹3.1k||₹2.9k||₹2.7k||₹2.5k||₹2.3k||₹2.2k||₹2.0k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹27b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (6.5%) 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%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = ₹8.2b× (1 + 6.5%) ÷ 15%– 6.5%) = ₹100b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹100b÷ ( 1 + 15%)10= ₹24b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is ₹52b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₹42.0, the company appears quite good value at a 44% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
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 Firstsource Solutions 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%, which is based on a levered beta of 1.107. 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. What is the reason for the share price to differ from the intrinsic value? For Firstsource Solutions, There are three additional aspects you should further research:
- Risks: For instance, we’ve identified 1 warning sign for Firstsource Solutions that you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for FSL’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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