In this article, we are going to estimate the intrinsic value of Power Grid Corporation of India Limited (NSE:POWERGRID) by taking the expected future cash flows and discounting them to their present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.

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 Power Grid Corporation of India

Step by step in the calculation

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

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Leveraged FCF (₹, million) ₹149.5 billion ₹180.7 billion ₹199.5 billion ₹205.5 billion ₹213.9 billion ₹224.3 billion ₹236.5 billion ₹250.3 billion ₹265.6 billion ₹282.3b Growth rate estimate Source Analyst x4 Analyst x4 Analyst x4 Is at 2.97% Is at 4.1% Is at 4.89% Is at 5.44% Is at 5.83% Is at 6.1% Is at 6.29% Present value (₹, million) discounted at 12% ₹133,600 ₹144,400 ₹142,500 ₹131,200 ₹122,100 ₹114,500 ₹107,900 ₹102,100 ₹96,800 ₹92,000

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = ₹1.2t

The second stage is also known as the terminal value, it is the cash flow of the business after 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 12%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹282b × (1 + 6.7%) ÷ (12%–6.7%) = ₹5.9t

Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹5.9t÷ ( 1 + 12%)ten= ₹1.9t

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹3.1t. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of ₹229, the company looks quite undervalued at a 48% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual 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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Power Grid Corporation of 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 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.

Look forward:

Although important, the DCF calculation is just one of many factors you need to assess for a business. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or in the risk-free rate can have a significant impact on the valuation. Why is the stock price below intrinsic value? For Power Grid Corporation of India, we have compiled three additional items for you to consider:

1. Risks: For example, we discovered 3 warning signs for Power Grid Corporation of India (2 make us uncomfortable!) that you should be aware of before investing here.
2. Future earnings: How does POWERGRID’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
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 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.

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.