Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Alfa, S.A.B. de C.V. (BMV:ALFAA) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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 (MX$, Millions)||Mex$12.3b||Mex$10.9b||Mex$10.4b||Mex$10.2b||Mex$10.3b||Mex$10.6b||Mex$11.1b||Mex$11.6b||Mex$12.3b||Mex$13.0b|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ -5.22%||Est @ -1.52%||Est @ 1.06%||Est @ 2.87%||Est @ 4.14%||Est @ 5.03%||Est @ 5.65%||Est @ 6.09%|
|Present Value (MX$, Millions) Discounted @ 16%||Mex$10.6k||Mex$8.1k||Mex$6.6k||Mex$5.6k||Mex$4.9k||Mex$4.4k||Mex$3.9k||Mex$3.5k||Mex$3.2k||Mex$2.9k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = Mex$54b
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 5-year average of the 10-year government bond yield of 7.1%. We discount the terminal cash flows to today's value at a cost of equity of 16%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = Mex$13b× (1 + 7.1%) ÷ (16%– 7.1%) = Mex$156b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= Mex$156b÷ ( 1 + 16%)10= Mex$35b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is Mex$89b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of Mex$15.4, the company appears about fair value at a 13% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Alfa. de 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 16%, which is based on a levered beta of 1.564. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Alfa. de, there are three fundamental factors you should consider:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Alfa. de , and understanding them should be part of your investment process.
- Future Earnings: How does ALFA A'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 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!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the BMV every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.