Is there an opportunity with the 30% undervaluation of Coal India Limited (NSE: COALINDIA)?
Does the February share price for Coal India Limited (NSE: COALINDIA) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. This may sound complicated, but it’s actually quite simple!
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
See our latest analysis for Coal India
crush numbers
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF (₹, million) | ₹195.2 billion | ₹176.3 billion | ₹159.4 billion | ₹152.3 billion | ₹150.6 billion | ₹152.5 billion | ₹156.9 billion | ₹163.3 billion | ₹171.2 billion | ₹180.5 billion |
Growth rate estimate Source | Analyst x10 | Analyst x10 | Analyst x6 | Is @ -4.44% | Is @ -1.09% | Is at 1.25% | Is @ 2.9% | Is at 4.05% | Is at 4.85% | Is at 5.42% |
Present value (₹, million) discounted at 15% | ₹170,200 | ₹134,100 | ₹105,700 | ₹88,100 | ₹76,000 | ₹67,100 | ₹60,200 | ₹54,700 | ₹50,000 | ₹46,000 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = ₹852b
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 6.7%. We discount terminal cash flows to present value at a cost of equity of 15%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = ₹180b × (1 + 6.7%) ÷ (15%–6.7%) = ₹2.4t
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= ₹2.4t÷ ( 1 + 15%)^{ten}= ₹619b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹1.5t. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of ₹167, the company looks quite undervalued at a 30% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.
Important assumptions
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. 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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Coal India as a potential shareholder, 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 15%, which is based on a leveraged beta of 1.235. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Look forward:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For Coal India, we have compiled three other factors that you should consider in more detail:
- Risks: For example, we discovered 1 warning sign for Coal India which you should be aware of before investing here.
- Future earnings: How does COALIINDIA’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs an updated cash flow valuation for each NSEI stock each day. If you want to find the calculation for other stocks, 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.