I am going to run you through how I calculated the intrinsic value of Allison Transmission Holdings, Inc. (NYSE:ALSN) by estimating the company’s future cash flows and discounting them to their present value. I will use the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for Allison Transmission Holdings by following the link below.
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Crunching the numbers
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
|Levered FCF ($, Millions)||$746.30||$669.27||$586.50||$535.30||$556.60|
|Source||Analyst x5||Analyst x3||Analyst x1||Analyst x1||Est @ 3.98%|
|Present Value Discounted @ 13.18%||$659.39||$522.47||$404.54||$326.22||$299.70|
Present Value of 5-year Cash Flow (PVCF)= US$2.2b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.7%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 13.2%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = US$557m × (1 + 2.7%) ÷ (13.2% – 2.7%) = US$5.5b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$5.5b ÷ ( 1 + 13.2%)5 = US$2.9b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$5.2b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $39.79. Compared to the current share price of $47.27, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Allison Transmission Holdings as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 13.2%, which is based on a levered beta of 1.437. This is derived from the Bottom-Up Beta method based on 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 shouldn’t be the only metric you look at when researching a company. For ALSN, I’ve put together three pertinent aspects you should further examine:
- Financial Health: Does ALSN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does ALSN’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: Are there other high quality stocks you could be holding instead of ALSN? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.