Does the December share price for Indraprastha Gas Limited (NSE: IGL) reflect what it is really worth? Today we’re going to estimate the intrinsic value of the stock by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Don’t be put off by the lingo, the underlying calculations are actually pretty straightforward.
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something that interests you.
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Crunch the numbers
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.
In general, 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:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (â¹, Millions)||8.54b||â¹ 13.0b||16.5b||â¹ 20.0b||â¹ 23.4b||â¹ 26.6b||29.7b||â¹ 32.7b||â¹ 35.7b||â¹ 38.7b|
|Source of estimated growth rate||Analyst x1||Analyst x1||Est @ 27.15%||East @ 21.03%||Est @ 16.74%||Est @ 13.74%||Est @ 11.64%||Est @ 10.17%||Est @ 9.14%||Est @ 8.42%|
|Present value (â¹, millions) discounted at 12%||â¹ 7.6k||10.4k||â¹ 11.9k||â¹ 12.9k||13.4k||13.7k||13.7k||13.5k||â¹ 13.2k||â¹ 12.8k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = â¹ 123b
We now need to calculate the Terminal Value, which takes into account all 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 used the 5-year average of the 10-year government bond yield (6.7%) to estimate future growth. Similar to the 10-year âgrowthâ period, we discount future cash flows to their present value, using a cost of equity of 12%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = â¹ 39b Ã (1 + 6.7%) Ã· (12% – 6.7%) = â¹ 829b
Present value of terminal value (PVTV)= TV / (1 + r)ten= â¹ 829b Ã· (1 + 12%)ten= 273b
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is â¹ 396b. In the last step, we divide the equity value by the number of shares outstanding. From the current share price of 492, the company appears to be roughly at fair value with a 13% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
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. 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 full picture of a company’s potential performance. Since we consider Indraprastha Gas 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.
While a business valuation is important, ideally it won’t be the only analysis you look at for a business. It is not possible to achieve a rock-solid valuation with a DCF model. 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 dramatically change the overall result. For Indraprastha Gas, we’ve compiled three additional things you should explore:
- Financial health: Does IGL have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future benefits: How does IGL’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
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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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.