Calculation of the fair value of Sonata Software Limited (NSE: SONATSOFTW)

How far is Sonata Software Limited (NSE: SONATSOFTW) 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. One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

See our latest review for Sonata Software

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 get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the latest 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) ₹ 3.48b ₹ 4.25b ₹ 5.37b ₹ 6.06b 6.73b ₹ 7.39b 8.04b ₹ 8.70b 9.38b ₹ 10.1b
Source of estimated growth rate Analyst x1 Analyst x2 Analyst x1 Est @ 12.87% Est @ 11.03% Est @ 9.74% Est @ 8.84% East @ 8.21% Est @ 7.77% Est @ 7.46%
Present value (₹, Millions) discounted at 13% ₹ 3.1k 3.3k ₹ 3.7k ₹ 3.7k ₹ 3.6k 3.5k ₹ 3.4k ₹ 3.2k ₹ 3.1k ₹ 2.9k

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = ₹ 33b

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. 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 13%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = ₹ 10b × (1 + 6.7%) ÷ (13% – 6.7%) = ₹ 166b

Present value of terminal value (PVTV)= TV / (1 + r)ten= 166b ÷ (1 + 13%)ten= ₹ 48b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is 82b. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of 791, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

NSEI Discounted Cash Flows: SONATSOFTW November 27, 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 complete picture of a company’s potential performance. Since we view Sonata Software 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 into account debt. In this calculation, we used 13%, which is based on a leveraged beta of 1.038. 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.

Next steps:

While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect stock assessment tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Sonata Software, we have put together three relevant aspects that you should take a closer look at:

  1. Risks: Consider, for example, the ever-present specter of investment risk. We have identified 2 warning signs with Sonata Software, and understanding them should be part of your investment process.
  2. Management: Have insiders increased their shares to take advantage of market sentiment about SONATSOFTW’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
  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. Simply Wall St updates its DCF calculation for every Indian stock every day, so if you want to find the intrinsic value of another stock 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 material. Simply Wall St has no position in any of the stocks mentioned.

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