Today we’re going to review one way to estimate the intrinsic value of Aurobindo Pharma Limited (NSE: AUROPHARMA) by taking expected future cash flows and discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest review for Aurobindo Pharma
We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (â¹, Millions)||â¹ 17.3b||â¹ 23.5b||24.9b||26.4b||â¹ 28.0b||29.7b||31.7b||â¹ 33.7b||â¹ 35.9b||â¹ 38.3b|
|Source of estimated growth rate||Analyst x11||Analyst x12||Analyst x8||Est @ 5.79%||Est @ 6.08%||East @ 6.27%||Est @ 6.41%||Est @ 6.51%||Est @ 6.58%||Est @ 6.63%|
|Present value (â¹, millions) discounted at 12%||15.5k||â¹ 18.8k||17.9k||16.9k||16.1k||15.3k||14.6k||â¹ 13.9k||â¹ 13.2k||12.6k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 155b
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 12%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = â¹ 38b Ã (1 + 6.7%) Ã· (12% – 6.7%) = â¹ 821b
Present value of terminal value (PVTV)= TV / (1 + r)ten= â¹ 821b Ã· (1 + 12%)ten= 271b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is â¹ 426b. In the last step, we divide the equity value by the number of shares outstanding. From the current share price of 710, the company is shown at fair value at a 2.3% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
We draw your attention to the fact 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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 full picture of a company’s potential performance. Since we view Aurobindo Pharma 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 takes into account debt. In this calculation, we used 12%, which is based on a leverage beta of 0.800. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Aurobindo Pharma, we have put together three relevant things that you should consider:
- Risks: You should be aware of the 3 warning signs for Aurobindo Pharma (1 is potentially serious!) That we discovered before considering an investment in the company.
- Management: Have insiders increased their shares to take advantage of market sentiment about AUROPHARMA’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NSEI share. If you want to find the calculation for other actions, just search here.
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