Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Carpentaria Resources Limited (ASX:CAP) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company’s last reported value. We assume companies with shrinking free cash flow are 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) forecast
|Levered FCF (A$, Millions)||AU$0.7||AU$0.7||AU$0.8||AU$0.8||AU$0.8||AU$0.8||AU$0.8||AU$0.8||AU$0.9||AU$0.9|
|Growth Rate Estimate Source||Est @ 0.99%||Est @ 1.39%||Est @ 1.67%||Est @ 1.86%||Est @ 2%||Est @ 2.09%||Est @ 2.16%||Est @ 2.2%||Est @ 2.24%||Est @ 2.26%|
|Present Value (A$, Millions) Discounted @ 8.82%||AU$0.7||AU$0.6||AU$0.6||AU$0.6||AU$0.5||AU$0.5||AU$0.5||AU$0.4||AU$0.4||AU$0.4|
Present Value of 10-year Cash Flow (PVCF)= A$5.12m
“Est” = FCF growth rate estimated by Simply Wall St
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 2.3%. We discount the terminal cash flows to today’s value at a cost of equity of 8.8%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = AU$881k × (1 + 2.3%) ÷ (8.8% – 2.3%) = AU$14m
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = A$AU$14m ÷ ( 1 + 8.8%)10 = A$5.94m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is A$11.07m. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of A$0.052. Compared to the current share price of A$0.056, the company appears around fair value at the time of writing. DCFs are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
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. 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 Carpentaria Resources 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 8.8%, which is based on a levered beta of 1.093. 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.
Whilst important, DCF calculation 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 Carpentaria Resources, I’ve put together three important factors you should further research:
- Financial Health: Does CAP 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of CAP? 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 AU stock every day, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.