Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Peter Warren Automotive Holdings Limited (ASX:PWR) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (A$, Millions)
AU$44.9m
AU$51.7m
AU$59.6m
AU$65.4m
AU$70.3m
AU$74.5m
AU$78.1m
AU$81.3m
AU$84.2m
AU$86.8m
Growth Rate Estimate Source
Analyst x3
Analyst x4
Analyst x4
Est @ 9.80%
Est @ 7.54%
Est @ 5.96%
Est @ 4.85%
Est @ 4.07%
Est @ 3.53%
Est @ 3.15%
Present Value (A$, Millions) Discounted @ 11%
AU$40.4
AU$41.7
AU$43.2
AU$42.6
AU$41.2
AU$39.2
AU$37.0
AU$34.6
AU$32.2
AU$29.8
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = AU$382m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 11%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$984m÷ ( 1 + 11%)10= AU$338m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$719m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$2.1, the company appears quite undervalued at a 50% 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.
dcf
Important Assumptions
We would point out 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 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 Peter Warren Automotive Holdings 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 11%, which is based on a levered beta of 1.962. 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.
SWOT Analysis for Peter Warren Automotive Holdings
Strength
Dividends are covered by earnings and cash flows.
Dividend is in the top 25% of dividend payers in the market.
Weakness
Earnings declined over the past year.
Interest payments on debt are not well covered.
Opportunity
Good value based on P/E ratio and estimated fair value.
Significant insider buying over the past 3 months.
Threat
Debt is not well covered by operating cash flow.
Annual earnings are forecast to decline for the next 3 years.
Looking Ahead:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Peter Warren Automotive Holdings, we've compiled three essential items you should consider:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PWR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock 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.
