An Intrinsic Calculation For Air Arabia PJSC (DFM:AIRARABIA) Suggests It's 43% Undervalued

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Air Arabia PJSC (DFM:AIRARABIA) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Air Arabia PJSC

Is Air Arabia PJSC fairly valued?

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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (AED, Millions)	د.إ1.65b	د.إ1.52b	د.إ1.11b	د.إ1.23b	د.إ1.11b	د.إ1.07b	د.إ1.07b	د.إ1.10b	د.إ1.15b	د.إ1.22b
Growth Rate Estimate Source	Analyst x1	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ -3.61%	Est @ 0.16%	Est @ 2.8%	Est @ 4.65%	Est @ 5.94%
Present Value (AED, Millions) Discounted @ 13%	د.إ1.5k	د.إ1.2k	د.إ773	د.إ757	د.إ606	د.إ518	د.إ460	د.إ419	د.إ389	د.إ365

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = د.إ6.9b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 9.0%. We discount the terminal cash flows to today's value at a cost of equity of 13%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = د.إ1.2b× (1 + 9.0%) ÷ (13%– 9.0%) = د.إ35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= د.إ35b÷ ( 1 + 13%)¹⁰= د.إ10b

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 د.إ17b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of د.إ2.1, the company appears quite good value at a 43% 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 assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Air Arabia PJSC 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 13%, which is based on a levered beta of 0.811. 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.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Air Arabia PJSC, we've put together three further elements you should explore:

1. Risks: You should be aware of the 3 warning signs for Air Arabia PJSC (1 shouldn't be ignored!) we've uncovered before considering an investment in the company.
2. Future Earnings: How does AIRARABIA'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 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 Emirian 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.