In this article, we’ll estimate the intrinsic value of Birlasoft Limited (NSE: BSOFT) by projecting its future cash flows and then discounting them to present value. Our analysis will use the discounted cash flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

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What is the estimated valuation?

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 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.

Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:

10-year free cash flow (FCF) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 34b

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. 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 13%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = ₹ 10.0b × (1 + 6.7%) ÷ (13% – 6.7%) = ₹ 177b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= ₹ 177b ÷ (1 + 13%)^ten= ₹ 53b

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹ 87b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of 415, the company looks potentially overvalued at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. 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 Birlasoft 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 13%, which is based on a leveraged beta of 0.968. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Looking forward:

While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Can we understand why the company is trading at a premium over intrinsic value? For Birlasoft, there are three essentials you should explore:

1. Risks: You should be aware of the 1 warning sign for Birlasoft we found out before considering an investment in the business.
2. Future benefits: How does BSOFT’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. 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.

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 shares 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.

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