Today we are going to give a simple overview of a valuation method used to estimate the attractiveness of Biocon Limited (NSE:BIOCON) as an investment opportunity by taking expected future cash flows of the company and discounting them to the current 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!
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check out our latest analysis for Biocon
Calculate numbers
We use what is called a 2-step 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.
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
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF (₹, million) | -₹15.1 billion | -₹24.1 billion | ₹14.6 billion | ₹23.4 billion | ₹33.7 billion | ₹44.8 billion | ₹56.0b | ₹66.9 billion | ₹77.4 billion | ₹87.5 billion |
Growth rate estimate Source | Analyst x7 | Analyst x5 | Analyst x2 | Is 59.98% | Is at 44.01% | East @ 32.83% | Is at 25.01% | Is at 19.53% | Is at 15.7% | Is at 13.01% |
Present value (₹, million) discounted at 12% | -13,500 ₹ | ₹ -19,100 | ₹10,300 | ₹14,700 | ₹18,800 | ₹22,200 | ₹24,700 | ₹26,300 | ₹27,100 | ₹27,200 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) =₹139b
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. 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 6.8%. We discount terminal cash flows to present value at a cost of equity of 12%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = ₹87b × (1 + 6.8%) ÷ (12%–6.8%) = ₹1.7t
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= ₹1.7t÷ ( 1 + 12%)^{ten}= ₹517b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹656b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of ₹296, the company appears to be pretty good value with a 46% discount to where the share price is currently trading. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.
The hypotheses
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the 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 or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Biocon 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 factors in debt. In this calculation, we used 12%, which is based on a leveraged beta of 0.876. 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.
Next steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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 pace, 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 Biocon, we’ve put together three relevant things you need to assess:
- Financial health: Does BIOCON have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
- Management: Did insiders increase their shares to take advantage of market sentiment about BIOCON’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- 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.
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