Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Acsm-Agam S.p.A. (BIT:ACS) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!
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. 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 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) estimate
|Levered FCF (€, Millions)||€22.2m||€27.1m||€31.4m||€35.1m||€38.1m||€40.7m||€42.8m||€44.6m||€46.1m||€47.5m|
|Growth Rate Estimate Source||Est @ 30.42%||Est @ 21.85%||Est @ 15.85%||Est @ 11.66%||Est @ 8.72%||Est @ 6.66%||Est @ 5.22%||Est @ 4.21%||Est @ 3.51%||Est @ 3.01%|
|Present Value (€, Millions) Discounted @ 8.6%||€20.5||€23.0||€24.5||€25.2||€25.2||€24.7||€24.0||€23.0||€21.9||€20.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €232m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 8.6%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = €48m× (1 + 1.9%) ÷ (8.6%– 1.9%) = €715m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €715m÷ ( 1 + 8.6%)10= €313m
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 €545m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of €2.3, the company appears about fair value at a 17% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
Now 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 Acsm-Agam 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 8.6%, which is based on a levered beta of 0.800. 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 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. 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. For Acsm-Agam, we've compiled three additional elements you should consider:
- Risks: Take risks, for example - Acsm-Agam has 1 warning sign we think you should be aware of.
- 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!
- Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!
PS. Simply Wall St updates its DCF calculation for every Italian stock every day, so if you want to find the intrinsic value of any other stock just search here.
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