Today we are going to give a simple overview of a valuation method used to estimate the attractiveness of Avadh Sugar & Energy Limited (NSE:AVADHSUGAR) as an investment opportunity by taking the flows expected future cash flows of the business and discounting them to today’s value. . The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at the Simply Wall St Analysis Template.
Check out our latest analysis for Avadh Sugar & Energy
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (₹, million)||₹1.54 billion||₹1.24 billion||₹1.09b||₹1.02b||₹999.7 million||₹1.00b||₹1.03b||₹1.06 billion||₹1.11 billion||₹1.17 billion|
|Growth rate estimate Source||East @ -30.92%||Is @ -19.63%||East @ -11.72%||Is @ -6.19%||Is @ -2.31%||Is at 0.4%||East @ 2.3%||Is at 3.63%||Is at 4.56%||Is at 5.21%|
|Present value (₹, million) discounted at 12%||₹1.4k||₹981||₹771||₹645||₹561||₹502||₹458||₹422||₹394||₹369|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = ₹6.5 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 6.7%. We discount terminal cash flows to present value at a cost of equity of 12%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹1.2b × (1 + 6.7%) ÷ (12%–6.7%) = ₹23b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹23b÷ ( 1 + 12%)ten= ₹7.1b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹14 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of ₹678, the company appears to be roughly fair value at a 0.7% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
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 entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Avadh Sugar & Energy 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 factors in debt. In this calculation, we used 12%, which is based on a leveraged beta of 0.858. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For Avadh Sugar & Energy, we’ve put together three fundamentals you should dig deeper into:
- Risks: For example, we have identified 3 warning signs for Avadh Sugar & Energy (1 should not be ignored) which you should be aware of.
- Future earnings: How does AVADHSUGAR’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
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 Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.