Does the April share price for WABCO Holdings (NYSE:WBC) reflect its intrinsic value? I am going to calculate it now using a method called discounted cash flow or DCF. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity by taking the expected Future Cash Flows and discounting them to their present valye. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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 WABCO Holdings
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. 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. We then discount this to its value today and sum up the total to get the present value of these cash flows.
The calculation
Please note that the numbers here are in millions apart from the per share values.
5-year cash flow forecast
2017 | 2018 | 2019 | 2020 | 2021 | |
Levered FCF (USD, Millions) | $276.70 | $319.57 | $327.00 | $358.00 | $366.61 |
Source | Analyst x6 | Analyst x6 | Analyst x1 | Analyst x1 | Extrapolated @ (2.4%) |
Present Value Discounted @ 9.11% | $253.61 | $268.45 | $251.77 | $252.64 | $237.12 |
Present value of next 5 years cash flows: $1,264
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the 5 years. The Perpetuity Method (Gordon Formula) is used to calculate Terminal Value at an annual growth rate equal to the 10 year government bond rate of (2.5%).
Terminal Value
Terminal Value = FCF_{2021} × (1 + g) ÷ (Discount Rate – g)
Terminal Value = $367 × (1 + 2.5%) ÷ (9.1% – 2.5%)
Terminal value based on the Perpetuity Method where growth (g) = 2.5%: $5,662
Present value of terminal value: $3,662
So the total value is the sum of the next 5 years cash flows and the terminal value discounted to today, this is known as the Equity Value.
Equity Value
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = $1,264 + $3,662 = $4,926
In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number.
Value = Total value / Shares Outstanding ($4,925.60 / 52.85)
Value per share: $93.19
Now when we compare the intrinsic value of 93.19 to the current share price of $117.77 we find WABCO Holdings (NYSE:WBC) is slightly overvalued at the time of writing.
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 WABCO Holdings 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 9.1% and this is based on a Levered Beta of 0.881. 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.
Conclusion
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. Is WABCO Holdings 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 NYSE every 6 hours. If you want to find the calculation for another other stock just search here.