Is There An Opportunity With American Woodmark Corporation's (NASDAQ:AMWD) 46% Undervaluation?

By
Simply Wall St
Published
January 20, 2022
NasdaqGS:AMWD
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of American Woodmark Corporation (NASDAQ:AMWD) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 American Woodmark

What's the estimated valuation?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 ($, Millions) US$22.7m US$98.2m US$112.0m US$122.1m US$130.6m US$137.6m US$143.7m US$148.9m US$153.6m US$157.9m
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x1 Est @ 9.03% Est @ 6.91% Est @ 5.43% Est @ 4.39% Est @ 3.66% Est @ 3.15% Est @ 2.79%
Present Value ($, Millions) Discounted @ 8.5% US$20.9 US$83.4 US$87.7 US$88.1 US$86.8 US$84.4 US$81.2 US$77.5 US$73.7 US$69.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$753m

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$158m× (1 + 2.0%) ÷ (8.5%– 2.0%) = US$2.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.5b÷ ( 1 + 8.5%)10= US$1.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$1.8b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$60.5, the company appears quite undervalued at a 46% discount to where the stock price trades currently. 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.

dcf
NasdaqGS:AMWD Discounted Cash Flow January 20th 2022

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 American Woodmark 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 8.5%, which is based on a levered beta of 1.493. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For American Woodmark, there are three pertinent factors you should consider:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with American Woodmark (at least 1 which shouldn't be ignored) , and understanding these should be part of your investment process.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AMWD's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. 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 NASDAQGS every day. If you want to find the calculation for other stocks just search here.

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