How far off is Waste Management, Inc. (NYSE:WM) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. To start off with, we need to estimate the next ten years of cash flows. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$1.95b||US$2.15b||US$2.30b||US$2.50b||US$2.64b||US$2.75b||US$2.84b||US$2.92b||US$2.99b||US$3.06b|
|Growth Rate Estimate Source||Analyst x10||Analyst x9||Analyst x3||Analyst x1||Analyst x1||Est @ 4.08%||Est @ 3.38%||Est @ 2.89%||Est @ 2.54%||Est @ 2.3%|
|Present Value ($, Millions) Discounted @ 7.0%||US$1.8k||US$1.9k||US$1.9k||US$1.9k||US$1.9k||US$1.8k||US$1.8k||US$1.7k||US$1.6k||US$1.6k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.7%. We discount the terminal cash flows to today’s value at a cost of equity of 7.0%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$3.1b× (1 + 1.7%) ÷ 7.0%– 1.7%) = US$60b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$60b÷ ( 1 + 7.0%)10= US$30b
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 US$48b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$96.7, the company appears about fair value at a 15% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 these result, have a go at the calculation yourself and play with the assumptions. 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 Waste Management 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 7.0%, which is based on a levered beta of 0.960. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and 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?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Waste Management, There are three pertinent factors you should look at:
- Risks: Every company has them, and we’ve spotted 2 warning signs for Waste Management you should know about.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for WM’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 US stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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