Is There An Opportunity With Atlas Arteria Limited's (ASX:ALX) 43% Undervaluation?

By
Simply Wall St
Published
August 10, 2021
ASX:ALX
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Atlas Arteria Limited (ASX:ALX) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Atlas Arteria

Crunching the numbers

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 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, 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$490.0m AU$529.3m AU$559.3m AU$596.9m AU$625.4m AU$649.8m AU$671.4m AU$690.8m AU$708.8m AU$725.8m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Analyst x2 Est @ 4.77% Est @ 3.91% Est @ 3.31% Est @ 2.9% Est @ 2.6% Est @ 2.4%
Present Value (A$, Millions) Discounted @ 7.8% AU$455 AU$456 AU$447 AU$443 AU$431 AU$415 AU$398 AU$380 AU$362 AU$344

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$4.1b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 7.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = AU$726m× (1 + 1.9%) ÷ (7.8%– 1.9%) = AU$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$13b÷ ( 1 + 7.8%)10= AU$6.0b

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$10b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$6.1, the company appears quite undervalued 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.

dcf
ASX:ALX Discounted Cash Flow August 10th 2021

The 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 Atlas Arteria 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 7.8%, which is based on a levered beta of 1.235. 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. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Atlas Arteria, we've put together three fundamental factors you should further research:

  1. Risks: Every company has them, and we've spotted 1 warning sign for Atlas Arteria you should know about.
  2. Future Earnings: How does ALX'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 Australian 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. 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.
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Simply Wall St is focused on providing unbiased, high-quality research coverage on every listed company in the world. Our research team consists of data scientists and multiple equity analysts with over two decades worth of financial markets experience between them.