Estimate of the fair value of Solara Active Pharma Sciences Limited (NSE: SOLARA)

Today we are going to walk through one way to estimate the intrinsic value of Solara Active Pharma Sciences Limited (NSE: SOLARA) by taking expected future cash flows and discounting them to present value. The DCF (Discounted Cash Flow) model is the tool we will apply to do this. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business and a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

Check out our latest review for Solara Active Pharma Sciences

The calculation

We use what’s called a 2-step model, which just means we have two different growth rate periods for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. First, we need to estimate the cash flow of the business over the next ten years. 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 last published value. We assume that companies with decreasing free cash flow will slow down their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow down during this period. We do this to reflect that growth tends to slow down more in the early years than in the following years.

Typically, 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 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) = ₹ 18 billion

Now we need to calculate the terminal value, which represents 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 14%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = ₹ 6.2 billion × (1 + 7.0%) ÷ (14% – 7.0%) = ₹ 96 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= ₹ 96b ÷ (1 + 14%)^ten= ₹ 26 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 ₹ 45 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 ₹ 1.3k, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

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 full picture of a company’s potential performance. Since we view Solara Active Pharma Sciences 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 into account debt. In this calculation, we used 14%, which is based on a leverage beta of 0.811. 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.

Next steps:

While valuing a business is important, it is just one of the many factors you need to assess for a business. The DCF model is not a perfect equity valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Solara Active Pharma Sciences, there are three important elements that you should consider in more detail:

1. Risks: As an example, we found 3 warning signs for Solara Active Pharma Sciences that you need to consider before investing here.
2. Future income: How does SOLARA’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!

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.

Promoted
When trading Solara Active Pharma Sciences or any other investment, use the platform seen by many as the trader’s gateway to the global market, Interactive Brokers. You benefit from the lowest * trading in stocks, options, futures, currencies, bonds and funds worldwide from a single integrated account.

This Simply Wall St article is general in nature. It is not a recommendation to buy or sell any stock, 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 any of the stocks mentioned.
^*Interactive Brokers ranked Least Expensive Broker by StockBrokers.com Annual Online Review 2020

Do you have comments on this article? Concerned about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.