Is there an opportunity with the 37% undervaluation of Graphite India Limited (NSE:GRAPHITE)?
Today we are going to give a simple overview of a valuation method used to estimate the attractiveness of Graphite India Limited (NSE: GRAPHITE) as an investment opportunity by taking future cash flows expected and discounting them to the present value. Our analysis will use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
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. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
See our latest analysis for Graphite India
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. In the first step, we need to estimate the company’s cash flow over 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (₹, million)||₹298.0 million||₹6.68 billion||₹12.4 billion||₹13.8 billion||₹15.2 billion||₹16.6 billion||₹18.0b||₹19.4 billion||₹20.9 billion||₹22.4 billion|
|Growth rate estimate Source||Analyst x1||Analyst x2||Analyst x2||Is at 11.56%||Is at 10.11%||Is at 9.1%||Is at 8.39%||Is at 7.89%||Is at 7.54%||Is at 7.3%|
|Present value (₹, million) discounted at 14%||₹261||₹5,100||₹8,300||₹8,100||₹7,800||₹7,400||₹7,000||₹6.7k||₹6,300||₹5,900|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) =₹63b
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 stage. For a number of reasons, a very conservative growth rate is used which 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 present value, using a cost of equity of 14%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹22b × (1 + 6.7%) ÷ (14%–6.7%) = ₹315b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹315b÷ ( 1 + 14%)ten=₹83b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹145 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of ₹472, the company seems to have quite good value with a 37% discount from the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now, 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 complete picture of a company’s potential performance. Since we consider Graphite India 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 1.182. 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.
While a business valuation is important, it shouldn’t be the only metric to consider when researching a business. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value higher than the current stock price? For Graphite India, we’ve rounded up three additional things for you to assess:
- Risks: For this purpose, you must know the 2 warning signs we spotted with Graphite India.
- Future earnings: How does GRAPHITE’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. Simply Wall St updates its DCF calculation for every Indian stock every day, so if you want to find the intrinsic value of any other stock, 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 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.