The intrinsic value of Bharat Petroleum Corporation Limited (NSE: BPCL) is potentially 25% lower than its share price

How far is Bharat Petroleum Corporation Limited (NSE: BPCL) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

Check out our latest analysis for Bharat Petroleum

What is the estimated valuation?

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. 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 stated 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 down more in the early years than in subsequent 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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leverage FCF (₹, Millions) ₹ 75.7b 76.8b 79.9b ₹ 83.1b ₹ 87.2b ₹ 92.0b 97.3b ₹ 103.3b 109.8b 116.8b
Source of estimated growth rate Analyst x8 Analyst x8 Analyst x6 Est @ 4.11% Is 4.9% East @ 5.45% Est @ 5.84% Est @ 6.11% East @ 6.3% Est @ 6.43%
Present value (₹, millions) discounted at 17% ₹ 64.8k 56.2k ₹ 50.0k 44.5k ₹ 39.9k 36.0k ₹ 32.6k ₹ 29.6k ₹ 26.9k 24.5k

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 405b

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 step. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 6.7%. We discount terminal cash flows to their present value at a cost of equity of 17%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = 117b × (1 + 6.7%) ÷ (17% – 6.7%) = ₹ 1.2t

Present value of terminal value (PVTV)= TV / (1 + r)ten= ₹ 1.2t ÷ (1 + 17%)ten= 257b

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₹ 662b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of 405, the company looks potentially overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

NSEI: BPCL Discounted Cash Flow November 22, 2021

Important assumptions

We draw your attention to the fact that 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 math yourself and play around with it. 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 Bharat Petroleum as a potential shareholder, 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 17%, which is based on a leveraged beta of 1.632. 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 comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Looking forward:

While important, calculating DCF is just one of the many factors you need to assess for a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company trades at a premium over its intrinsic value? For Bharat Petroleum, we have compiled three relevant factors to consider:

  1. Risks: To do this, you need to know the 3 warning signs we spotted with Bharat Petroleum.
  2. Future benefits: How does BPCL’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
  3. Other strong companies: Low debt, high returns on equity and good past performance are fundamental 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.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is 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 documents. Simply Wall St does not have any position in the mentioned stocks.

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