Treasury Wine Estates Limited (ASX:TWE) Shares Could Be 40% Below Their Intrinsic Value Estimate

By
Simply Wall St
Published
April 11, 2022
ASX:TWE
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Treasury Wine Estates Limited (ASX:TWE) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Treasury Wine Estates

The method

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 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) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (A$, Millions) AU$277.0m AU$271.5m AU$422.7m AU$535.0m AU$547.8m AU$559.0m AU$570.1m AU$581.0m AU$592.0m AU$603.0m
Growth Rate Estimate Source Analyst x5 Analyst x4 Analyst x5 Analyst x3 Analyst x2 Est @ 2.05% Est @ 1.98% Est @ 1.92% Est @ 1.89% Est @ 1.86%
Present Value (A$, Millions) Discounted @ 5.4% AU$263 AU$245 AU$361 AU$434 AU$422 AU$408 AU$395 AU$382 AU$370 AU$357

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$3.6b

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.8%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 5.4%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = AU$603m× (1 + 1.8%) ÷ (5.4%– 1.8%) = AU$17b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$17b÷ ( 1 + 5.4%)10= AU$10b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$14b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$11.5, the company appears quite undervalued at a 40% 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.

dcf
ASX:TWE Discounted Cash Flow April 11th 2022

The 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 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 Treasury Wine Estates 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 5.4%, which is based on a levered beta of 0.841. 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:

Whilst important, the DCF calculation is only one of many factors that you need to assess for 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Treasury Wine Estates, we've put together three relevant aspects you should assess:

  1. Risks: For instance, we've identified 1 warning sign for Treasury Wine Estates that you should be aware of.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for TWE's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

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