Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Onward Technologies Limited (NSE:ONWARDTEC) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (₹, Millions)
₹89.5m
₹97.0m
₹105.0m
₹113.3m
₹122.2m
₹131.7m
₹141.8m
₹152.7m
₹164.3m
₹176.8m
Growth Rate Estimate Source
Est @ 8.78%
Est @ 8.41%
Est @ 8.16%
Est @ 7.97%
Est @ 7.85%
Est @ 7.76%
Est @ 7.7%
Est @ 7.65%
Est @ 7.62%
Est @ 7.6%
Present Value (₹, Millions) Discounted @ 16.59%
₹76.8
₹71.4
₹66.2
₹61.3
₹56.7
₹52.4
₹48.4
₹44.7
₹41.3
₹38.1
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= ₹557.5m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 16.6%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = ₹₹2.1b ÷ ( 1 + 16.6%)10 = ₹453.52m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹1.01b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of ₹63.7. Relative to the current share price of ₹60.45, the company appears about fair value at a 5.1% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
NSEI:ONWARDTEC Intrinsic value, September 2nd 2019
Important 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 Onward Technologies 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 16.6%, which is based on a levered beta of 1.051. 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 Onward Technologies, There are three further aspects you should further examine:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of ONWARDTEC? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every IN stock every day, so if you want to find the intrinsic value of any other stock 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.
