Today we are going to walk through one way to estimate the intrinsic value of Caplin Point Laboratories Limited (NSE: CAPLIPOINT) by projecting its future cash flows and then discounting them to present value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are 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. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.
Check out our latest analysis for Caplin Point Laboratories
What is the estimated valuation?
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
|Leveraged FCF (₹, million)||₹1.43 billion||₹2.29 billion||₹2.81 billion||₹3.31 billion||₹3.79b||₹4.26 billion||₹4.71b||₹5.15b||₹5.60b||₹6.05b|
|Growth rate estimate Source||Analyst x1||Analyst x1||East @ 22.76%||Is 17.95%||Is at 14.59%||East @ 12.23%||Is at 10.59%||Is at 9.43%||Is at 8.62%||Is at 8.06%|
|Present value (₹, million) discounted at 12%||₹1,300||₹1.8k||₹2,000||₹2,100||₹2,200||₹2,200||₹2,200||₹2,100||₹2,100||₹2,000|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = ₹20b
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 12%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹6.0b × (1 + 6.7%) ÷ (12%–6.7%) = ₹130b
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹130b÷ ( 1 + 12%)ten=₹43b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹63b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of ₹788, the company appears to be roughly fair value at a 4.6% 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.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the 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 Caplin Point Laboratories 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 leveraged beta of 0.800. 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 important, the DCF calculation will ideally not be the only piece of analysis you look at for a business. DCF models are not the be-all and end-all of investment valuation. 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, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For Caplin Point Laboratories, we have compiled three fundamentals that you should consider:
- Risks: For example, we have identified 2 warning signs for Caplin Point Laboratories (1 should not be ignored) which you should be aware of.
- Management:Have insiders increased their shares to take advantage of market sentiment on CAPLIPOINT’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
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.