Today we’re going to go over one way to estimate the intrinsic value of Ajanta Pharma Limited (NSE: AJANTPHARM) by projecting its future cash flows and then discounting them to present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.

There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

Discover our latest analysis for Ajanta Pharma

Step by step in the calculation

We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. 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) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = ₹ 55b

The second stage is also known as terminal value, it is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 6.7%. We discount the terminal cash flows to their present value at a cost of equity of 12%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = 15b × (1 + 6.7%) ÷ (12% – 6.7%) = ₹ 327b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= ₹ 327b ÷ (1 + 12%)^ten= ₹ 108b

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 163b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of 2.1k, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. 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 Ajanta Pharma 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 12%, which is based on a leverage beta of 0.800. 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.

Move on :

While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. It is not possible to achieve a rock-solid valuation with a DCF model. 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. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Ajanta Pharma, there are three important aspects that you need to consider:

1. Risks: Concrete example, we have spotted 1 warning sign for Ajanta Pharma you must be aware.
2. Future benefits: How does AJANTPHARM’s growth rate compare to that of its peers and the wider market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. 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.