RESEARCH: What is market pricing in compared to my DCF price? Case study – Wipro Limited

Introduction

The intrinsic value of a stock is the sum of its future cash flows discounted by the cost of capital. Analysts and investors frequently use the Discounted Cash Flow (DCF) valuation to ascertain potential investment opportunities (undervalued stocks). However, the DCF method involves a fair bit of guesstimates, which make the forecast unreliable. In fact, it is next to impossible to accurately forecast the performance of any business. This is one of the reasons why analysts prefer a market-based approach (relative valuation) compared to an income-based approach (intrinsic valuation) due to its simplicity and real time data (in the form of comparables).

Typical DCF inputs include revenue growth, profit margins, reinvestment rate, target capital structure, cost of capital, steady state cash flows, and steady state growth rate. The multiplicity of variables makes the estimated price extremely sensitive to estimates, especially the perpetual growth rate.

While an analyst’s view about a stock is colored with his own outlook on the stock and the sector, stock prices provide a ready reference to check the expectations of the entire market. The trading price reflects the market sentiments and any news related to the company or the sector. By using the techniques of reverse DCF, we can back calculate the variables priced by the market. Often there have been cases where stocks enter into a momentum phase where the market begins to price in a perpetual decline or an irrational high growth rate for its future cash flows. These market estimates are embedded in the trading price of any stock. By reviewing the market embedded variables, one can gauge the divergence between the trading price and an analyst’s estimates about the fair price.

We used the technique of 3-variable sensitivity tables (which is a separate topic in itself and will be covered in future posts) to back calculate market expectations.

Case study – Wipro Ltd.

Step 1: The first step in determining the implied assumptions embedded in the market price is to build an abbreviated DCF model. We pulled the company actuals using third party databases like Bloomberg and applied conservative estimates to project growth. In this case, we have projected the financials using the historical trends. As Wipro is an exporter of IT services, its earnings remain exposed to forex movement. While the company’s recent growth in revenue could be partly due to the weakening of INR against USD, we believe the cycle is upward looking and the company will continue to post healthy results. Hence, we have resorted to the historical trends to project the cash flows for Wipro. The historical trends imply a constant revenue growth of 12% and a constant EBITDA margin of roughly 21%.

All figures in INR million, except per unit data

Source: Bloomberg

Step 2: The next step is to make assumptions regarding the WACC and the terminal value to arrive at a guesstimate price. For this example, we have assumed a constant WACC of 9.3% and an EV/EBITDA exit multiple of 11.5x, which implies an inherent growth rate of roughly 5.5%. The assumptions for WACC and EBITDA margin have been kept in line with the street.

·         WACC = 9.3%

·         Exit multiple = 11.5x

Step 3: The next step is to run the DCF analysis and find out the intrinsic value of the stock. The estimated price comes out to be INR 678.

All figures in INR million, except per unit data

Step 4: As shown in the above table, the upside to the current market price using conservative estimates shows the current price to be undervalued. We understand that the implied share price reflects the weakness of the DCF method in forecasting the cost of capital and growth rates. To cross check our assumptions, we will break down the current market price of Wipro to compare our estimates with the market.

In the following table, we have sensitized the numbers using a 3-D sensitivity table to determine the assumptions factored in by the market. As shown, the current stock price of INR 560 assumes a perpetual growth rate of 6–10%, which reflects the broader GDP movement.

 Note: The share prices in red are in the range of INR 550–570.

Step 5 : Interpretation of 3-variable sensitivity analysis:

• At the present share price of INR 560, the stock price implies a lower revenue growth of 6–10%, with a perpetual growth rate of 5.5%, EBITDA margin of 19–23%, and cost of equity of 9.3%.
• In our analysis, we had assumed a near-term growth in revenue of around 12%, with the perpetual growth rate aligned more with the broader economy (long-term potential of India’s GDP growth), EBITDA margin of 21% (historical average), and cost of equity of 9.3% based on which our DCF value for Wipro is INR 678.
• The primary difference between our estimated price and the trading price remains the expectation on the revenue growth trends between 2014 and 2020. We believe the company has a higher potential and the recent correction in stock relative to the Sensex looks unwarranted as the market is pricing in a very low revenue growth for a technology stock like Wipro

DISCLAIMER: This  example is used to explain how we can deduce the market assumptions for perpetual growth priced-in in the share price of any company and see if it is fairly priced compared to an anlyst’s assumptions. We don’t recommend any trading in the stock based on this analysis and advise to use your own bottom-up model to validate your assumptions.