In this article we are going to estimate the intrinsic value of Honeywell International Inc. (NYSE:HON) by taking the foreast future cash flows of the company and discounting them back to today’s value. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
Step by step through the calculation
We’re 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 a stable growth rate. 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.
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$5.36b||US$5.83b||US$6.23b||US$6.57b||US$6.83b||US$7.05b||US$7.25b||US$7.43b||US$7.60b||US$7.76b|
|Growth Rate Estimate Source||Analyst x11||Analyst x10||Analyst x3||Analyst x2||Est @ 3.94%||Est @ 3.28%||Est @ 2.82%||Est @ 2.5%||Est @ 2.27%||Est @ 2.11%|
|Present Value ($, Millions) Discounted @ 7.1%||US$5.0k||US$5.1k||US$5.1k||US$5.0k||US$4.8k||US$4.7k||US$4.5k||US$4.3k||US$4.1k||US$3.9k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$46b
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 1.7%. We discount the terminal cash flows to today’s value at a cost of equity of 7.1%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$7.8b× (1 + 1.7%) ÷ 7.1%– 1.7%) = US$146b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$146b÷ ( 1 + 7.1%)10= US$73b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$120b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$132, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Honeywell International 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 7.1%, which is based on a levered beta of 0.994. 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.
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?” 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. What is the reason for the share price to differ from the intrinsic value? For Honeywell International, We’ve compiled three fundamental aspects you should further examine:
- Risks: Case in point, we’ve spotted 2 warning signs for Honeywell International you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for HON’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 email@example.com. 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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