Stock Analysis

Ducommun Incorporated (NYSE:DCO) Shares Could Be 41% Below Their Intrinsic Value Estimate

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NYSE:DCO
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Today we will run through one way of estimating the intrinsic value of Ducommun Incorporated (NYSE:DCO) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 Ducommun

The method

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 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) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$44.4m US$53.5m US$60.3m US$66.0m US$70.8m US$74.8m US$78.2m US$81.2m US$83.9m US$86.3m
Growth Rate Estimate Source Analyst x3 Analyst x2 Est @ 12.65% Est @ 9.47% Est @ 7.24% Est @ 5.68% Est @ 4.59% Est @ 3.82% Est @ 3.29% Est @ 2.91%
Present Value ($, Millions) Discounted @ 8.0% US$41.1 US$45.8 US$47.8 US$48.4 US$48.1 US$47.0 US$45.5 US$43.8 US$41.8 US$39.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$449m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.0%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$86m× (1 + 2.0%) ÷ (8.0%– 2.0%) = US$1.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.5b÷ ( 1 + 8.0%)10= US$678m

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$1.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$56.8, the company appears quite good value at a 41% 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.

dcf
NYSE:DCO Discounted Cash Flow January 23rd 2021

Important assumptions

Now 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 Ducommun 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 8.0%, which is based on a levered beta of 1.146. 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.

Moving On:

Although the valuation of a company is important, 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value higher than the current share price? For Ducommun, we've compiled three pertinent factors you should further research:

  1. Risks: To that end, you should learn about the 3 warning signs we've spotted with Ducommun (including 1 which can't be ignored) .
  2. Future Earnings: How does DCO'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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