How far off is Talbros Automotive Components Limited (NSE:TALBROAUTO) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today’s value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
What’s the estimated valuation?
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, 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)||₹349.0m||₹389.3m||₹429.0m||₹468.5m||₹508.5m||₹549.5m||₹592.0m||₹636.5m||₹683.2m||₹732.5m|
|Growth Rate Estimate Source||Est @ 13.54%||Est @ 11.57%||Est @ 10.19%||Est @ 9.22%||Est @ 8.54%||Est @ 8.07%||Est @ 7.73%||Est @ 7.5%||Est @ 7.34%||Est @ 7.23%|
|Present Value (₹, Millions) Discounted @ 21%||₹288||₹266||₹242||₹219||₹196||₹175||₹156||₹139||₹123||₹109|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹1.9b
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 (7.0%) 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 21%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₹733m× (1 + 7.0%) ÷ (21%– 7.0%) = ₹5.6b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₹5.6b÷ ( 1 + 21%)10= ₹835m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹2.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of ₹249, the company appears around fair value at the time of writing. 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 Talbros Automotive Components 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 21%, which is based on a levered beta of 1.654. 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…