Estimating The Intrinsic Value Of Alfa Laval AB (publ) (STO:ALFA)

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Alfa Laval AB (publ) (STO:ALFA) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

See our latest analysis for Alfa Laval

Is Alfa Laval fairly valued?

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. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (SEK, Millions) kr5.66b kr4.90b kr4.93b kr4.95b kr4.98b kr5.00b kr5.03b kr5.05b kr5.08b kr5.10b
Growth Rate Estimate Source Analyst x7 Analyst x7 Analyst x5 Est @ 0.52% Est @ 0.51% Est @ 0.51% Est @ 0.5% Est @ 0.5% Est @ 0.5% Est @ 0.49%
Present Value (SEK, Millions) Discounted @ 6.9% kr5.3k kr4.3k kr4.0k kr3.8k kr3.6k kr3.4k kr3.2k kr3.0k kr2.8k kr2.6k

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = kr36b

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 10-year government bond rate of 0.5%. We discount the terminal cash flows to today’s value at a cost of equity of 6.9%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = kr5.1b× (1 + 0.5%) ÷ 6.9%– 0.5%) = kr80b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= kr80b÷ ( 1 + 6.9%)10= kr41b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is kr77b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of kr190, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.

OM:ALFA Intrinsic value June 16th 2020
OM:ALFA Intrinsic value June 16th 2020

Important assumptions

Now 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 Alfa Laval 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 6.9%, which is based on a levered beta of 1.065. 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.

Next Steps:

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 Alfa Laval, We’ve put together three important factors you should further research:

  1. Financial Health: Does ALFA have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does ALFA’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every SE 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. 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. Thank you for reading.