In this article we are going to estimate the intrinsic value of Transurban Group (ASX:TCL) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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. 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.
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 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.
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$1.04b||AU$1.53b||AU$1.69b||AU$2.02b||AU$2.18b||AU$2.29b||AU$2.40b||AU$2.49b||AU$2.57b||AU$2.65b|
|Growth Rate Estimate Source||Analyst x5||Analyst x6||Analyst x6||Analyst x2||Analyst x2||Est @ 5.42%||Est @ 4.47%||Est @ 3.81%||Est @ 3.34%||Est @ 3.02%|
|Present Value (A$, Millions) Discounted @ 8.0%||AU$959||AU$1.3k||AU$1.3k||AU$1.5k||AU$1.5k||AU$1.4k||AU$1.4k||AU$1.3k||AU$1.3k||AU$1.2k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$13b
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 (2.3%) 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 8.0%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU$2.6b× (1 + 2.3%) ÷ (8.0%– 2.3%) = AU$47b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$47b÷ ( 1 + 8.0%)10= AU$22b
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$35b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$13.6, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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. 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 Transurban 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 8.0%, which is based on a levered beta of 0.959. 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.
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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Transurban Group, we've compiled three essential items you should look at:
- Risks: Be aware that Transurban Group is showing 2 warning signs in our investment analysis , you should know about...
- Future Earnings: How does TCL'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.
When trading Transurban Group or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email firstname.lastname@example.org.