Today we'll do a simple run through of a valuation method used to estimate the attractiveness of T.T. Limited (NSE:TTL) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (₹, Millions)
₹147.6m
₹163.1m
₹178.8m
₹194.9m
₹211.6m
₹229.1m
₹247.5m
₹267.1m
₹287.9m
₹310.1m
Growth Rate Estimate Source
Est @ 11.78%
Est @ 10.51%
Est @ 9.62%
Est @ 9%
Est @ 8.57%
Est @ 8.26%
Est @ 8.05%
Est @ 7.9%
Est @ 7.79%
Est @ 7.72%
Present Value (₹, Millions) Discounted @ 24.54%
₹118.5
₹105.2
₹92.6
₹81.0
₹70.6
₹61.4
₹53.3
₹46.1
₹39.9
₹34.5
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= ₹703.0m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 7.6%. We discount the terminal cash flows to today's value at a cost of equity of 24.5%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = ₹₹2.0b ÷ ( 1 + 24.5%)10 = ₹218.55m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹921.55m. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of ₹41.72. Relative to the current share price of ₹36.55, the company appears about fair value at a 12% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
NSEI:TTL Intrinsic value, September 3rd 2019
The assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 T.T 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 24.5%, which is based on a levered beta of 1.976. 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.
Next Steps:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For T.T, I've put together three additional aspects you should further examine:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of TTL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NSE every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
