Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Art's-Way Manufacturing Co., Inc. (NASDAQ:ARTW) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at 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 begin with, we have to get estimates of 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$166.7k||US$284.3k||US$426.3k||US$578.0k||US$725.4k||US$859.3k||US$975.4k||US$1.07m||US$1.16m||US$1.22m|
|Growth Rate Estimate Source||Est @ 99.92%||Est @ 70.54%||Est @ 49.98%||Est @ 35.58%||Est @ 25.5%||Est @ 18.45%||Est @ 13.51%||Est @ 10.05%||Est @ 7.64%||Est @ 5.94%|
|Present Value ($, Millions) Discounted @ 7.8%||US$0.2||US$0.2||US$0.3||US$0.4||US$0.5||US$0.5||US$0.6||US$0.6||US$0.6||US$0.6|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$4.0m
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 (2.0%) 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 7.8%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.2m× (1 + 2.0%) ÷ (7.8%– 2.0%) = US$22m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$22m÷ ( 1 + 7.8%)10= US$10m
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 US$14m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$3.2, 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Art's-Way Manufacturing 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 7.8%, which is based on a levered beta of 1.221. 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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Art's-Way Manufacturing, we've compiled three relevant items you should explore:
- Risks: As an example, we've found 3 warning signs for Art's-Way Manufacturing (1 can't be ignored!) that you need to consider before investing here.
- 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!
- Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQCM every day. If you want to find the calculation for other stocks just search here.
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Art's-Way Manufacturing Co., Inc. manufactures and sells agricultural equipment, specialized modular science buildings, and steel cutting tools in the United States and internationally.
Acceptable track record with imperfect balance sheet.