Are Investors Undervaluing Huntington Ingalls Industries, Inc. (NYSE:HII) By 48%?

By
Simply Wall St
Published
January 12, 2022
NYSE:HII
Source: Shutterstock

In this article we are going to estimate the intrinsic value of Huntington Ingalls Industries, Inc. (NYSE:HII) by taking the forecast future cash flows of the company and discounting them back to today's 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Huntington Ingalls Industries

Is Huntington Ingalls Industries fairly valued?

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. To start off with, we need to estimate 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.

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) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$498.6m US$752.2m US$834.5m US$836.3m US$842.3m US$851.5m US$863.0m US$876.3m US$890.9m US$906.5m
Growth Rate Estimate Source Analyst x5 Analyst x5 Analyst x4 Analyst x4 Est @ 0.72% Est @ 1.09% Est @ 1.35% Est @ 1.54% Est @ 1.66% Est @ 1.75%
Present Value ($, Millions) Discounted @ 6.9% US$466 US$658 US$683 US$640 US$603 US$570 US$541 US$513 US$488 US$465

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.6b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 6.9%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$906m× (1 + 2.0%) ÷ (6.9%– 2.0%) = US$19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$19b÷ ( 1 + 6.9%)10= US$9.6b

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$15b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$199, the company appears quite good value at a 48% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NYSE:HII Discounted Cash Flow January 12th 2022

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 Huntington Ingalls Industries 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 6.9%, which is based on a levered beta of 1.131. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. 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. What is the reason for the share price sitting below the intrinsic value? For Huntington Ingalls Industries, we've compiled three pertinent items you should further examine:

  1. Risks: Take risks, for example - Huntington Ingalls Industries has 3 warning signs we think you should be aware of.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for HII's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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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