Today we will run through one way of estimating the intrinsic value of Illinois Tool Works Inc. (NYSE:ITW) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching The Numbers
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.
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
|Levered FCF ($, Millions)||US$3.09b||US$3.11b||US$3.48b||US$3.67b||US$3.81b||US$3.93b||US$4.05b||US$4.15b||US$4.25b||US$4.35b|
|Growth Rate Estimate Source||Analyst x10||Analyst x5||Analyst x3||Analyst x3||Est @ 3.87%||Est @ 3.29%||Est @ 2.89%||Est @ 2.6%||Est @ 2.4%||Est @ 2.26%|
|Present Value ($, Millions) Discounted @ 6.4%||US$2.9k||US$2.8k||US$2.9k||US$2.9k||US$2.8k||US$2.7k||US$2.6k||US$2.5k||US$2.4k||US$2.3k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$27b
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 (1.9%) 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 6.4%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$4.3b× (1 + 1.9%) ÷ (6.4%– 1.9%) = US$100b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$100b÷ ( 1 + 6.4%)10= US$54b
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$81b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$195, the company appears a touch undervalued at a 25% 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.
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 Illinois Tool Works 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 6.4%, which is based on a levered beta of 1.043. 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.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Illinois Tool Works, there are three further elements you should assess:
- Risks: For instance, we've identified 1 warning sign for Illinois Tool Works that you should be aware of.
- Future Earnings: How does ITW'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 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Illinois Tool Works
Illinois Tool Works Inc. manufactures and sells industrial products and equipment worldwide.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
|Analysis Area||Score (0-6)|
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Established dividend payer with mediocre balance sheet.