Does the March share price for JK Tyre & Industries Limited (NSE:JKTYRE) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by projecting its future cash flows and then discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. 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. Anyone interested in learning a bit more about intrinsic value should have a read of 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, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
|Levered FCF (₹, Millions)||₹15.3b||₹8.76b||₹8.41b||₹9.55b||₹10.7b||₹11.8b||₹12.8b||₹13.9b||₹15.1b||₹16.2b|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Est @ 13.6%||Est @ 11.61%||Est @ 10.22%||Est @ 9.24%||Est @ 8.56%||Est @ 8.08%||Est @ 7.74%|
|Present Value (₹, Millions) Discounted @ 24%||₹12.4k||₹5.7k||₹4.4k||₹4.1k||₹3.7k||₹3.3k||₹2.9k||₹2.5k||₹2.2k||₹1.9k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹43b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 7.0%. We discount the terminal cash flows to today’s value at a cost of equity of 24%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₹16b× (1 + 7.0%) ÷ (24%– 7.0%) = ₹103b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹103b÷ ( 1 + 24%)10= ₹12b
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 ₹55b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of ₹124, the company appears quite good value at a 44% 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.
Now 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 JK Tyre & Industries 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 24%, which is based on a levered beta of 2.000. 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.