In this article I am going to calculate the intrinsic value of Air New Zealand (NZSE:AIR) by taking the expected future cash flows and discounted them to the value today. A discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows to a stock. It sounds complicated, but actually it is quite simple!
Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Please also note that this article was written in April 2017 so be sure check out the updated calculation by following the link below. View our latest analysis for Air New Zealand
I use what is known as a 2-stage model, which simply means we have two different periods where we need to estimate cash flows. In the 1st stage we need to estimate the cash flows to the business over the next 5 years, where possible I use analysts estimates but when these aren’t available I have extrapolated the previous Free Cash Flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past 5 years, but capped to a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
Detailed calculation
Please note that the numbers here are in millions apart from the per share values.
5-year cash flow estimate
2017 | 2018 | 2019 | 2020 | 2021 | |
Levered FCF (NZD, Millions) | $236.00 | $336.00 | $135.00 | $139.89 | $144.96 |
Source | Analyst x1 | Analyst x1 | Analyst x1 | Extrapolated @ (3.62%) | Extrapolated @ (3.62%) |
Present Value Discounted @ 8.55% | $217.41 | $285.14 | $105.54 | $100.75 | $96.17 |
Present value of next 5 years cash flows: $805
The 2nd stage is also known as Terminal Value, this is the cash flows to the business after the 1st stage. For a number of reasons a very conservative rate is used that cannot exceed that of the GDP. In this case I have used the 10 year government bond rate (2.8%). In the same way as with the 5 year ‘growth’ period we discount this to today’s value.
Terminal Value
Terminal Value = FCF_{2021} × (1 + g) ÷ (Discount Rate – g)
Terminal Value = $145 × (1 + 2.8%) ÷ (8.6% – 2.8%)
Terminal value based on the Perpetuity Method where growth (g) = 2.8%: $2,572
Present value of terminal value: $1,706
The total value or equity value is then the sum of of the present value of the cash flows.
Equity Value
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = $805 + $1,706 = $2,511
To get the intrinsic value we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR to get the intrinsic value per share.
Value = Total value / Shares Outstanding ($2,511.32 / 1,122.78)
Value per share: $2.24
Finally if we compare the intrinsic value of 2.24 to the current share price of $2.47 we see Air New Zealand (NZSE:AIR) is slightly overvalued and not available at a discount at this time.
Important assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Air New Zealand as potential investors the Cost of Equity is used as the discount rate, not the Cost of Capital (or Weighed Average Cost of Capital/ WACC) which accounts for debt.
In this calculation I’ve used 8.6% and this is based on a Levered Beta of 0.8. I’m not going to go into how I calculate the Levered Beta in detail, I used the ‘Bottom up Beta’ method based on the comparable businesses, I also impose a limit between 0.8 and 2 which is a reasonable range for a stable business. Google this if you want to learn more.
Final Words
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. Is Air New Zealand in a healthy financial condition? What is the reason for the share price to differ from the intrinsic value? See our latest FREE analysis to find out!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NZSE every 6 hours. If you want to find the calculation for another other stock just search here.