Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. A prime example of conflicts between valuation models is Maruti Suzuki India Limited’s (NSEI:MARUTI). While my discounted cash flow (DCF) model tells me that it is undervalued by 99.87%, my relative valuation model says it is overvalued by 55.96%. So, which model is more reliable and why?

See our latest analysis for Maruti Suzuki India

A closer look at intrinsic valuation

At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. To obtain the per share intrinsic value of MARUTI, we must first discount the sum of MARUTI’s future FCFs by 13.4%, which gives us an equity value of ₹1.34T. Then, we divide this by 302.08M shares outstanding to get a per share target price of ₹4439.69. In other words, on average, broker analysts believe that MARUTI is currently trading above fair value at ₹8873.45. Check out the source of my intrinsic value here.,

But how accurate is this figure? Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. MARUTI’s final year FCF growth rate of -1.36%, is too low. If this assumption held true, MARUTI would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. The downside is that forecasts are less reliable the further into the future they are.

Deep-dive into relative valuation

The basic principle of relative valuation is that two companies with near identical characteristics should be priced similarly. But a big issue here is actually finding companies that are similar to MARUTI, so I’ve used the Auto industry as a proxy. To calculate the “true” value of MARUTI, we multiply MARUTI’s earnings by the industry’s P/E ratio to obtain a share price of ₹3907.52, which means MARUTI is overvalued. But is this a dependable conclusion?

To check the robustness of our relative valuation, let’s take a look at if MARUTI has a similar growth profile to the overall Auto industry. With a projected earnings growth rate of 10.18% for next year, MARUTI has a significantly different growth profile when compared with the Auto industry, which is projected to grow at 21.03%. This demonstrates that the Auto industry is a weak proxy for MARUTI, which undermines our relative valuation analysis. Alternatively, manually selecting companies that shared similar growth profiles with MARUTI could vastly improve our analysis. I’d encourage you to do this by taking a look at MARUTI’s competitors.