Are Investors Undervaluing Tata Power Company Limited (NSE:TATAPOWER) By 40%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Tata Power fair value estimate is ₹638
• Current share price of ₹382 suggests Tata Power is potentially 40% undervalued
• The ₹418 analyst price target for TATAPOWER is 34% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Tata Power Company Limited (NSE:TATAPOWER) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

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Crunching The Numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (₹, Millions)	-₹80.4b	-₹75.7b	-₹71.4b	₹17.0b	₹66.0b	₹108.6b	₹159.8b	₹215.8b	₹273.2b	₹329.6b
Growth Rate Estimate Source	Analyst x7	Analyst x6	Analyst x4	Analyst x1	Analyst x1	Est @ 64.50%	Est @ 47.18%	Est @ 35.07%	Est @ 26.58%	Est @ 20.65%
Present Value (₹, Millions) Discounted @ 13%	-₹71.3k	-₹59.5k	-₹49.8k	₹10.5k	₹36.2k	₹52.8k	₹68.9k	₹82.6k	₹92.7k	₹99.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹262b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this 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 have used the 5-year average of the 10-year government bond yield (6.8%) 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 13%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = ₹330b× (1 + 6.8%) ÷ (13%– 6.8%) = ₹5.9t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹5.9t÷ ( 1 + 13%)¹⁰= ₹1.8t

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹2.0t. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of ₹382, the company appears quite good value at a 40% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Tata Power 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 accounts for debt. In this calculation we've used 13%, which is based on a levered beta of 0.800. Beta is a measure of a stock's volatility, compared 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.

View our latest analysis for Tata Power

SWOT Analysis for Tata Power

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Tata Power, we've compiled three further factors you should look at:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Tata Power (including 1 which is concerning) .
2. Future Earnings: How does TATAPOWER's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts 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 article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.