Stock Analysis

HCL Technologies Limited (NSE:HCLTECH) Shares Could Be 21% Above Their Intrinsic Value Estimate

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NSEI:HCLTECH
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Today we will run through one way of estimating the intrinsic value of HCL Technologies Limited (NSE:HCLTECH) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for HCL Technologies

Step By Step Through The Calculation

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, 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) forecast

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$1.67b US$1.92b US$2.12b US$2.21b US$2.32b US$2.44b US$2.58b US$2.74b US$2.91b US$3.10b
Growth Rate Estimate Source Analyst x22 Analyst x22 Analyst x12 Analyst x1 Est @ 4.81% Est @ 5.4% Est @ 5.8% Est @ 6.09% Est @ 6.29% Est @ 6.42%
Present Value ($, Millions) Discounted @ 13% US$1.5k US$1.5k US$1.5k US$1.3k US$1.2k US$1.2k US$1.1k US$1.0k US$951 US$894

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$12b

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 5-year average of the 10-year government bond yield (6.8%) 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 13%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$3.1b× (1 + 6.8%) ÷ (13%– 6.8%) = US$51b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$51b÷ ( 1 + 13%)10= US$15b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$27b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of ₹956, the company appears slightly overvalued at the time of writing. 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.

dcf
NSEI:HCLTECH Discounted Cash Flow September 13th 2022

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 HCL Technologies 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 13%, which is based on a levered beta of 1.011. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess 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?" 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. Why is the intrinsic value lower than the current share price? For HCL Technologies, we've compiled three fundamental factors you should further examine:

  1. Risks: You should be aware of the 1 warning sign for HCL Technologies we've uncovered before considering an investment in the company.
  2. Future Earnings: How does HCLTECH'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 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. Simply Wall St updates its DCF calculation for every Indian stock every day, so if you want to find the intrinsic value of any other stock just search here.

Valuation is complex, but we're helping make it simple.

Find out whether HCL Technologies is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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About NSEI:HCLTECH

HCL Technologies

HCL Technologies Limited offers software development, business process outsourcing, and infrastructure management services worldwide.

The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.

Analysis AreaScore (0-6)
Valuation3
Future Growth2
Past Performance5
Financial Health5
Dividends4

Read more about these checks in the individual report sections or in our analysis model.

Solid track record with excellent balance sheet and pays a dividend.