Calculating The Intrinsic Value Of Trustpower Limited (NZSE:TPW)

Today we will run through one way of estimating the intrinsic value of Trustpower Limited (NZSE:TPW) 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

Check out our latest analysis for Trustpower

Is Trustpower fairly valued?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NZ$, Millions)	NZ$125.0m	NZ$119.9m	NZ$117.3m	NZ$116.4m	NZ$116.5m	NZ$117.3m	NZ$118.8m	NZ$120.6m	NZ$122.7m	NZ$125.0m
Growth Rate Estimate Source	Est @ -6.79%	Est @ -4.07%	Est @ -2.17%	Est @ -0.84%	Est @ 0.09%	Est @ 0.75%	Est @ 1.2%	Est @ 1.52%	Est @ 1.75%	Est @ 1.9%
Present Value (NZ$, Millions) Discounted @ 6.5%	NZ$117	NZ$106	NZ$97.3	NZ$90.6	NZ$85.2	NZ$80.6	NZ$76.7	NZ$73.1	NZ$69.9	NZ$66.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$863m

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. 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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 6.5%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NZ$125m× (1 + 2.3%) ÷ (6.5%– 2.3%) = NZ$3.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$3.1b÷ ( 1 + 6.5%)¹⁰= NZ$1.6b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$2.5b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$8.1, the company appears around fair value at the time of writing. 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.

The assumptions

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. 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 Trustpower 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 6.5%, 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.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Trustpower, there are three important factors you should further research:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Trustpower (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
2. Future Earnings: How does TPW'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 New Zealander 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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