Stock Analysis

BlueScope Steel Limited (ASX:BSL) Shares Could Be 40% Below Their Intrinsic Value Estimate

•  Updated

Today we will run through one way of estimating the intrinsic value of BlueScope Steel Limited (ASX:BSL) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (A\$, Millions) AU\$1.30b AU\$970.5m AU\$728.0m AU\$903.2m AU\$796.0m AU\$777.6m AU\$769.4m AU\$768.0m AU\$771.3m AU\$778.0m Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x4 Analyst x2 Analyst x2 Est @ -2.31% Est @ -1.06% Est @ -0.18% Est @ 0.44% Est @ 0.87% Present Value (A\$, Millions) Discounted @ 7.7% AU\$1.2k AU\$836 AU\$582 AU\$670 AU\$549 AU\$497 AU\$457 AU\$423 AU\$395 AU\$369

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU\$6.0b

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 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = AU\$778m× (1 + 1.9%) ÷ (7.7%– 1.9%) = AU\$14b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU\$14b÷ ( 1 + 7.7%)10= AU\$6.4b

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 AU\$12b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU\$16.3, the company appears quite good value at a 40% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 BlueScope Steel 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 7.7%, which is based on a levered beta of 1.143. 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:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 BlueScope Steel, there are three important elements you should consider:

1. Risks: Be aware that BlueScope Steel is showing 3 warning signs in our investment analysis , and 1 of those is significant...
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BSL'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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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