Does the July share price for Fortescue Metals Group Limited (ASX:FMG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$6.37b||US$4.25b||US$3.85b||US$3.01b||US$4.48b||US$4.50b||US$4.53b||US$4.58b||US$4.65b||US$4.72b|
|Growth Rate Estimate Source||Analyst x8||Analyst x7||Analyst x3||Analyst x2||Analyst x1||Est @ 0.32%||Est @ 0.8%||Est @ 1.14%||Est @ 1.37%||Est @ 1.54%|
|Present Value ($, Millions) Discounted @ 7.0%||US$5.9k||US$3.7k||US$3.1k||US$2.3k||US$3.2k||US$3.0k||US$2.8k||US$2.7k||US$2.5k||US$2.4k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$32b
The second stage is also known as Terminal Value, this is the business's cash flow after 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 (1.9%) 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 7.0%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$4.7b× (1 + 1.9%) ÷ (7.0%– 1.9%) = US$94b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$94b÷ ( 1 + 7.0%)10= US$48b
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$79b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$23.6, the company appears quite undervalued at a 31% 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.
Now 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 Fortescue Metals Group 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 7.0%, which is based on a levered beta of 1.082. 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, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. What is the reason for the share price sitting below the intrinsic value? For Fortescue Metals Group, there are three relevant items you should further research:
- Risks: You should be aware of the 2 warning signs for Fortescue Metals Group (1 is a bit concerning!) we've uncovered before considering an investment in the company.
- Future Earnings: How does FMG'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.
- 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. 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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