Heritage Foods: Discounted Cash Flow Valuation

Case

Author: Varun Dawar

Online Pub Date: January 02, 2019 | Original Pub. Date: 2019
Subject: Valuation, Investment Banking
Level: | Type: Indirect case | Length: 2460
Copyright: © Varun Dawar 2019
Organization: Heritage Foods | Organization size: Large
Region: Southern Asia | State:
Industry: Manufacture of food products
Publisher: SAGE Publications: SAGE Business Cases Originals
DOI: https://dx.doi.org/10.4135/9781526467201 | Online ISBN: 9781526467201
SAGE Business Cases
© Varun Dawar 2019

© Varun Dawar 2019

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https://dx.doi.org/10.4135/9781526467201

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Abstract
In August 2017, Rakesh Singh, an equity research analyst was looking at the annual report of
Heritage Foods, a leading dairy player headquartered in Hyderabad, India. Rakesh had been
assigned to value Heritage Foods to determine its potential undervaluation or overvaluation of
the current market traded price; he used the traditional discounted cash flow (DCF) methodology
based on available financial information. The case puts students in the role of an equity
analyst wherein they conduct DCF valuation for Heritage Foods in order to discover potential
undervalued stock for investment decision making.

Case

Learning Outcomes

By the end of this case study, students should be able to:

• apply the concept and framework of equity valuation and modalities of discounted cash flow (DCF)
valuation methodology;
• calculate the weighted average cost of capital (WACC) to determine a discounting rate;
• compute the free cash flows to the firm (FCFF) required for performing DCF valuation;
• discuss terminal value and its computation; and
• conduct overall financial valuation for a target company using the multistage DCF model for
investment decision making.

Introduction

In August 2017, Rakesh Singh, an equity research analyst, was reviewing the annual financials of Heritage
Foods, a dairy company headquartered in Hyderabad, India. As part of a consumer sector valuation team,
Rakesh had been assigned to value Heritage Foods to determine the undervaluation or overvaluation of its
traded market price. Heritage Foods, primarily in the business of milk, milk products, and ice cream/frozen
desserts, is one of the fastest growing dairy companies in India. With an organized dairy segment expected
to grow at a compound annual growth rate (CAGR) of 19.5% during 2015–2020 (Heritage Foods, 2017) along
with rising disposable incomes in India, Heritage Foods was poised to enlarge its presence across various
markets. Rakesh wondered whether Heritage Foods would turn out to be an undervalued or overvalued stock
given its current market-traded price of INR 1,400 (commanding an equity market capitalization of around INR
3,200 crores (USD 1 billion = 100 crore)). He chose to value Heritage Foods using the traditional discounted
cash flow (DCF) model and available financial information.

Heritage Foods

Heritage Foods, a leading dairy player with a strong presence in southern regional markets operates mainly in
two segments—dairy and renewable energy. The company’s dairy products are sold under the Heritage brand
across ten states in India through 6,098 distributors and 1,457 Heritage Parlours (Parlours are exclusive
outlets selling the whole range of Heritage products that include Heritage milk, milk products, ice cream,
bread, etc.); it enjoys leadership in the states of Andhra Pradesh and Telangana, and it holds sizeable market
shares in the states of Tamil Nadu and Karnataka.

While 80% of the company’s dairy revenues come from south India, going forward the company is targeting
further growth by scaling Tier II (population between 50,000 and 100,000) and Tier III towns (population
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between 20,000 and 50,000). In the dairy segment, the company has grown, with milk procurement level
crossing 1 million liters per day. Further, the company strengthened its presence in northern regions through
inorganic strategies (such as acquisitions) in the dairy space. The company has recently acquired the dairy
business Reliance Retail Ltd, which now gives it reach into five new states: Punjab, Haryana, Himachal,
Uttarakhand, and Rajasthan.

Heritage has also set a target to become a USD 1 billion company by 2022. Along with organic growth in
liquid milk and value-added products, Heritage has been looking for growth through inorganic strategies. With
revenues at a CAGR of 10.5% over the last four years, the dairy division has constituted almost 70% of the
company’s progress. But with increasing demand for value-added products, dairy revenue has increased from
12% to nearly 23% in the current fiscal year 2017 to register a CAGR of 17.79% over the last four years. As
of fiscal year 2017, curd contributes 77% of total value-added product revenue, followed by frozen dessert,
paneer, flavored milk, and sweets (Heritage Foods, 2017).

In renewable energy, the company has increased its renewable energy capacity to 8.2 MW with 2.35 MW of
solar power, 1.66 MW of distributed solar power, and 4.20 MW of wind power in the states of Andhra Pradesh,
Telangana, Maharashtra, Tamil Nadu, and Karnataka for exclusive consumption by its dairy plants (Heritage
Foods, 2017).

Indian Dairy Industry

The Indian dairy industry is one of the fastest growing dairy segments in the world (with the annual growth rate
being 4.6% as compared to global growth rate of 2.2%) and provides employment opportunities across rural
and semi-urban areas (70–76 million households are involved in the dairy industry) (Care Ratings, 2017). In
an otherwise monsoon-dependent country like India, the dairy industry has been a pillar of livelihood. The
segment is driven by milk collection, transportation, processing, and distribution networks. The importance
of the dairy industry for rural economies is underscored by the fact that India has become the largest global
producer of milk since 1998, outpacing other large milk-producing nations such as the United States. While
domestic milk production recorded about 4.3% CAGR, reaching about 147 million tons in 2015–2016, from
116 million tons in 2009–2010, other milk-producing nations recorded only about 2–3% CAGR over the past
five years. Furthermore, in India the increase in production of milk has managed to outpace the growth in
population, thereby increasing per capita consumption (Heritage Foods, 2016).

The unorganized sector of the Indian dairy industry commands an almost 80% market share; the remaining
percentage is the organized sector. While the organized dairy sector consists mainly of cooperatives and
private diaries, the unorganized segment comprises traditional milkmen/vendors and self-consumption (at
home). In terms of growth, the organized segment is expected to grow at a CAGR of 19.5% during 2015–2020
and account for almost 25.5% of the Indian dairy industry by the year 2020. Similarly, the unorganized
segment is expected to grow at a CAGR of 13.2% during the same period and account for 74.5% of the total
Indian dairy industry by 2020 (Heritage Foods, 2017).

In terms of the product breakdown in the dairy industry of India, liquid milk comprises almost 65% of the
share, followed by ghee (with 15% share of the dairy market). While traditional value-added dairy products
(VADP) like paneer, curd, and butter together constitute 32% of India’s total dairy market, the emerging VADP
account for 2.3%. Going forward, with rising disposable incomes and a bourgeoning proportion of working
women, consumption of ready-to-eat products, branded cheese, table butter, flavored milk, paneer, buttermilk,
and so on is likely to increase significantly (Heritage Foods, 2017). As per analyst report estimates, product
categories such as cheese, flavored milk, butter milk, and flavored and frozen yogurt are expected to grow at
double digit CAGR (Edelweiss Equity Report, 2017).

Financial Performance and Management Outlook

During the financial year ending March 31, 2017 (FY17), Heritage registered a revenue growth of 11% on the
back of rapid strides in the Mumbai and Delhi markets in its dairy business, vertical in addition to its market

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leadership in southern markets. In terms of profitability, profit after tax (PAT) during the year stood at INR
66.8 crores, up 20% from last year driven by the increased contributions from value-added products (where
profit margins are higher) to the overall portfolio. The company has a comfortable capital position with net
worth increasing at a CAGR of 20% over the last five years. In terms of distribution to shareholders, dividend
appropriated has increased steadily from 30% in FY13 to 40% in FY17. With many new players entering
the high-shelf-life, value-added products market, the company has been increasing its intensity of capital
expenditure on account of higher fixed capex as well as enhanced working capital requirement (Edelweiss
Equity Report, 2017). The competitive landscape includes Hatsun Agro Products, Parag Milk Foods, Prabhat
Dairy, and Kwality. In terms of milk processing capacity, Kwality is the largest player (3.4 million liters per day)
followed by Hatsun (3 million liters per day), and Parag (2 million liters per day) (Edelweiss Equity Report,
2017). The company, however, operates with a comfortable cash position generating about INR 97 crores of
operating cash flow in FY17.

Valuing Heritage Foods: Multi-Stage DCF Valuation

The DCF valuation approach involves finding the present value of all future free cash flows during the
forecasted period and then discounting it at the weighted average cost of capital (WACC) to arrive at the
intrinsic value of the stock.

Projecting Future Free Cash Flows

To perform the DCF valuation, Rakesh Singh needed to explicitly forecast the free cash flows of Heritage
Foods using the various financial data available in the annual report (for FY17; see Tables 1 and 2). Singh was
confident that Heritage Foods can grow its revenue by 10% each year going forward given management’s
positive outlook, favorable demographics, a shift from the unorganized to organized sector, and strong
financial position of the company. Some of the other assumptions made by Singh were as follows.

• Cost of materials consumed (as percentage of revenue) was assumed to be in line with current year
(FY17) levels in foreseeable future.
• Employee and other expenses (as percentage of revenue) were assumed to be in line with current
year levels (FY17) levels.
• Depreciation (as percentage of revenue) was assumed in line with current year (FY17) levels
• Working capital (as percentage of revenue) was assumed in line with current year (FY17) levels.
• Dividend payout ratio was assumed at 15%, similar to the current year.
• Capital expenditure as percentage of revenue assumed as 3.5% of revenues each year (in line with
previous year levels).
• Tax rate was assumed as 30%.
• Cost of debt (pre-tax) was assumed as 8.5%.
• Terminal growth rate (gterminal) can be assumed as 5%.

Table 1. Heritage Foods Income Statement

Income statement

Heritage Foods (in crores) FY16 FY17

Income

Revenue from operations (net) 2,380 2,643

Other income 7 6

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Total revenue 2,387 2,649

Expenses

Cost of materials consumed 1,879 2,063

Power and fuel 29 28

Employee benefits expense 139.99 164.72

Finance costs 15.49 11.22

Depreciation and amortization expense 34.51 37.8

Other expenses 201.68 246.16

Profit before exceptional and extraordinary items and tax 87 98

Exceptional Items 1 0

Profit before tax 86 98

Tax 31 31

Profit after tax 55.01 67

Weighted average number of equity shares outstanding (in crores) 2.3199 2.3199

Earnings per share (EPS) 23.7 28.9

Dividend per share 3 4

Table 2. Heritage Foods Balance Sheet

Heritage Foods (in crores) FY16 FY17

Equity and liabilities

Shareholders’ funds 240 303

Share capital 23.19 23.19

Reserves and surplus 217 280

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Non-current liabilities

Long-term borrowings 65.84 69.45

Deferred tax liabilities (net) 18.68 19.08

Other long-term liabilities 10.45 11.48

Long-term provisions 5.51 4.89

Current liabilities

Short-term borrowings 39.25 65.87

Trade payables 84.66 50.75

Other current liabilities 94.70 107.16

Short-term provisions 15.82 5.98

Total 575 638

Assets

Fixed assets

Property, plant, and equipment 310 281

Intangible assets 2 0

Capital work-in-progress 10 8

Non-current investments 1 149

Long-term loans and advances 24 17

Other non-current assets 1 1

Current assets

Current investments 0.02 0.02

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Inventories 145 116

Trade receivables 29 11

Cash and bank balances 45 46

Short-term loans and advances 7 8

Other current assets 2 1

Total 575 638

Singh assumed that the company would continue to maintain its current debt/equity ratio in the foreseeable
future. The final consideration for Rakesh was to determine the WACC to be used as a discounting factor. To
compute the same, Rakesh needed to estimate cost of equity. For this he estimated beta for Heritage Foods
to be 0.5 and average equity risk premium for India as 4%. Finally Singh assumed the risk-free rate as 7%.

With all this financial information in hand, Rakesh decided to first forecast the income statement and balance
sheet of Heritage Foods between the years 2018 and 2027 and then arrive at a fair fundamental price of
Heritage Foods using the DCF valuation methodology so as to determine its undervaluation or overvaluation.

Discussion Questions

1. Discuss the concept and framework of equity valuation in the context of Heritage Foods.
2. Discuss the modalities of DCF valuation methodology and its main assumptions for valuation of
Heritage Foods. Is the DCF valuation method an appropriate way to value Heritage Foods?
3. Estimate the computation of FCFF required for performing DCF valuation of Heritage Foods.
4. Determine the fair fundamental valuation of Heritage Foods (on a per share basis) using the multi-
stage DCF methodology. Clearly state all your assumptions and calculations including an estimation
of WACC (for required returns).
5. Based on your analysis, as Rakesh Singh, determine the undervaluation or overvaluation of
Heritage Foods relative to its currently traded market price? As Rakesh Singh, what is your
recommendation for investment decision making in shares of Heritage Foods.

Further Reading

Damodaran, A. , 2016. Damodaran on valuation: Security analysis for investment and corporate finance (Vol.
324). Hoboken, NJ: John Wiley & Sons.
Hatsun Agro. (2017). Annual report. Retrieved from https://www.hap.in/pdf/annualreport/2017.pdf
Hindu Business Line. (2016). Heritage Foods to buy dairy business of Reliance Retail. Retrieved from
https://www.thehindubusinessline.com/companies/heritage-foods-to-buy-dairy-business-of-reliance-retail/
article9282270.ece
Imam, S. , Barker, R. , & Clubb, C. (2008). The use of valuation models by UK investment analysts. European
Accounting Review, 17, 503–535.
Koller, T. , Goedhart, M. , & Wessels, D. (2015). Valuation: Measuring and managing the value of companies,
6th ed. Hoboken, NJ: John Wiley & Sons.
Kwality. (2017). Annual report. Retrieved from http://www.kwality.com/investor-relations#annualReport
Luehrman, T. A. (1997). What’s it worth? A general manager’s guide to valuation. Harvard Business Review,
75, 132–142.
Penman, S. H. (1998). A synthesis of equity valuation techniques and the terminal value calculation for the
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dividend discount model. Review of Accounting Studies, 2, 303–323.

Penman, S. H. , & Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings approaches to
equity valuation. Contemporary Accounting Research, 15, 343–383.
Sunidhi Equity Report. (2017). Equity research report. Retrieved from http://www.heritagefoods.in/images/
Heritage%20Foods-Q3FY17RU_Sunidhi140217%20(2).pdf
The Hindu. (2017). Dairy sector to witness robust growth this year: Experts. Retrieved from
http://www.thehindu.com/news/national/kerala/Dairy-sector-to-witness-robust-growth-this-year-experts/
article17008703.ece

References

Care Ratings. (2017). Indian dairy industry - Driven by value-added products. Retrieved from
http://www.careratings.com/upload/NewsFiles/SplAnalysis/
Indian%20Dairy%20Industry%20-%20driven%20by%20value-added%20products.pdf
Edelweiss Equity Report. (2017). Equity research report. Retrieved from http://www.heritagefoods.in/images/
heritage-14.02.2017-edelweiss.pdf
Heritage Foods. (2016). Annual report. Retrieved from http://www.heritagefoods.in/images/
HFL_ANNUAL%20REPORT_2015-16.pdf
Heritage Foods. (2017). Annual report. Retrieved from http://www.heritagefoods.in/images/25thAR16-17.pdf
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