A look at the fair value of Setco Automotive Limited (NSE:SETCO)

Key findings

• The estimated fair value of Setco Automotive is ₹14.53 million based on 2-step Free Cash Flow to Equity
• The current share price of ₹12.01 suggests that Setco Automotive may be trading close to its fair value
• Setco Automotive’s competitors are currently trading at an average premium of 936%.

How far is Setco Automotive Limited (NSE:SETCO) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by taking the expected future cash flows and discounting them to their present value. One way to do this is by applying the Discounted Cash Flow (DCF) model. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

Companies can be valued in many ways, so we want to point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, you can read the basics of this calculation in detail in Simply Wall St’s analysis model.

Check out our latest analysis for Setco Automotive

The method

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally, the first stage is higher growth and the second stage is a lower growth period. First, we need to estimate the next ten years’ cash flows. Since we don’t have analyst estimates of free cash flow available, we extrapolated the previous free cash flow (FCF) from the company’s last reported value. We assume that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the 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. Therefore, the sum of these future cash flows is discounted to today’s value:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = ₹1.4 billion

After calculating the present value of future cash flows in the first 10-year period, we need to calculate the terminal value, which takes into account all future cash flows after the first period. For various reasons, a very conservative growth rate is used, which cannot exceed 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. In the same way as with the 10-year “growth” period, we discount future cash flows to today’s value, using a cost of equity of 22%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = ₹557m × (1 + 6.7%) ÷ (22% – 6.7%) = ₹3.8b

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= ₹3.8 billion ÷ (1 + 22%)¹⁰= ₹508 million

The total value or equity value is then the sum of the present value of future cash flows, which in this case is ₹1.9 billion. The final step is to divide the equity value by the number of shares outstanding. Relative to the current share price of ₹12.0, the company appears roughly fairly valued, at a 17% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it is better to consider this as a rough estimate that is not accurate to the last penny.

The assumptions

We would like to point out that the key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs and therefore does not provide a complete picture of a company’s potential performance. Since we consider Setco Automotive 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 22%, which is based on a leveraged beta of 2,000. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Setco Automotive

Go on:

Valuation is only one side of the coin in building your investment thesis and just one of many factors you need to evaluate for a company. The DCF model is not a perfect stock valuation tool. Instead, a DCF model is best suited to testing certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. For example, making a small adjustment to the terminal value growth rate can dramatically change the overall result. For Setco Automotive, there are three relevant points you should evaluate:

1. Risks: We think you should 4 warning signs for Setco Automotive (2 are significant!) that we marked before investing in the company.
2. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!
3. More top analyst tips: Want to know what the analysts think? Take a look at our interactive list of analyst recommended stocks and find out which stocks they think could have attractive future prospects!

PS The Simply Wall St app runs a discounted cash flow valuation for every stock on the NSEI every day. If you want to find the calculation for other stocks, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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