Do investors undervalue NCC Limited (NSE: NCC) by 26%?

In this article, we will estimate the intrinsic value of NCC Limited (NSE: NCC) by taking expected future cash flows and discounting them to present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!

There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for every situation. For those who are learning equity analysis in depth, the Simply Wall St analysis template here may be of interest to you.

See our latest analysis for NCC

The method

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 the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the following years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:

10-year Free Cash Flow (FCF) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = ₹ 44 billion

Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. For a number of reasons, a very conservative growth rate is used that 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 (7.0%) 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 17%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = ₹ 13 billion × (1 + 7.0%) ÷ (17% – 7.0%) = ₹ 141 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= 141b ₹ ÷ (1 + 17%)^ten= ₹ 30 billion

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is ₹ 74 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of ₹ 89.1, the company appears to be 26% undervalued compared to the current share price. Assumptions in any calculation have a big impact on the valuation, so it’s best to think of this as a rough estimate, not precise down to the last penny.

The hypotheses

Now the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. Part of investing is making 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 view NCC 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 17%, which is based on a leveraged beta of 1.149. 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 globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Looking forward:

Valuation is only one side of the coin in terms of building your investment thesis, and ideally it won’t be the only analysis you look at for a business. The DCF model is not a perfect equity valuation tool. Preferably, you apply different cases and assumptions and see how they would impact the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Why is intrinsic value greater than the current share price? For NCC, we’ve compiled three other aspects that you should take a closer look at:

1. Risks: Take, for example, the ubiquitous spectrum of investment risk. We have identified 1 warning sign with NCC, and understand that this should be part of your investment process.
2. Management: Have insiders increased their stocks to take advantage of market sentiment for NCC’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. 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 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. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in the mentioned stocks.
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