Estimating The Intrinsic Value Of HCL Infosystems Limited (NSE:HCL-INSYS)

Key Insights

• The projected fair value for HCL Infosystems is ₹21.00 based on 2 Stage Free Cash Flow to Equity
• With ₹18.25 share price, HCL Infosystems appears to be trading close to its estimated fair value
• Peers of HCL Infosystems are currently trading on average at a 373% premium

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of HCL Infosystems Limited (NSE:HCL-INSYS) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for HCL Infosystems

The Method

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. To begin with, we have to get estimates of 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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (₹, Millions)	₹628.3m	₹724.2m	₹816.2m	₹905.2m	₹992.5m	₹1.08b	₹1.17b	₹1.26b	₹1.35b	₹1.45b
Growth Rate Estimate Source	Est @ 18.94%	Est @ 15.27%	Est @ 12.70%	Est @ 10.91%	Est @ 9.65%	Est @ 8.77%	Est @ 8.15%	Est @ 7.72%	Est @ 7.42%	Est @ 7.20%
Present Value (₹, Millions) Discounted @ 18%	₹534	₹524	₹502	₹473	₹441	₹408	₹375	₹344	₹314	₹286

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹4.2b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 6.7%. We discount the terminal cash flows to today's value at a cost of equity of 18%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = ₹1.4b× (1 + 6.7%) ÷ (18%– 6.7%) = ₹14b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹14b÷ ( 1 + 18%)¹⁰= ₹2.8b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹7.0b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of ₹18.3, the company appears about fair value at a 13% 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.

The 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 HCL Infosystems 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 18%, which is based on a levered beta of 1.395. 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:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 HCL Infosystems, we've compiled three pertinent aspects you should consider:

1. Risks: Be aware that HCL Infosystems is showing 4 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...
2. 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!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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.

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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.