Calculation of the fair value of Finolex Cables Limited (NSE: FINCABLES)
Today we will review a valuation method used to estimate the attractiveness of Finolex Cables Limited (NSE: FINCABLES) as an investment opportunity by taking expected future cash flows and discounting them at today’s value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.
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. Anyone interested in learning a bit more about intrinsic value should read the Simply Wall St.
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We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth, and the second stage is lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. 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, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year free cash flow (FCF) forecast
|Leverage FCF (₹, Millions)||₹ 4.85b||₹ 3.64b||₹ 5.53b||6.60b||₹ 7.63b||₹ 8.61b||9.56b||₹ 10.5b||₹ 11.4b||₹ 12.4b|
|Source of estimated growth rate||Analyst x1||Analyst x2||Analyst x1||Is 19.3%||Is 15.53%||Est @ 12.89%||Est @ 11.05%||East @ 9.76%||Est @ 8.85%||East @ 8.22%|
|Present value (₹, millions) discounted at 14%||₹ 4.3k||₹ 2.8k||₹ 3.7k||₹ 3.9k||4.0k||₹ 3.9k||₹ 3.8k||₹ 3.7k||3.5k||3.3k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 37b
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. 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 “growth” period, we discount future cash flows to their present value, using a cost of equity of 14%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹ 12b × (1 + 6.7%) ÷ (14% – 6.7%) = ₹ 183b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹ 183b ÷ (1 + 14%)ten= ₹ 49b
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 86b. The last step is then to divide the equity value by the number of shares outstanding. From the current stock price of 553, the company appears to be roughly at fair value at a 2.2% discount from where the stock price is currently trading. 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. 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 Finolex Cables 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 debt into account. In this calculation, we used 14%, which is based on a leveraged beta of 1.160. 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 that 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, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Finolex cables, we have compiled three relevant items that you should take a closer look at:
- Risks: Take risks, for example – Finolex Cables has 1 warning sign we think you should be aware.
- Future benefits: How does FINCABLES ‘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 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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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.