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- NYSE:NOC
Northrop Grumman Corporation's (NYSE:NOC) Intrinsic Value Is Potentially 30% Above Its Share Price
Key Insights
- Northrop Grumman's estimated fair value is US$609 based on 2 Stage Free Cash Flow to Equity
- Current share price of US$468 suggests Northrop Grumman is potentially 23% undervalued
- Our fair value estimate is 21% higher than Northrop Grumman's analyst price target of US$503
Does the November share price for Northrop Grumman Corporation (NYSE:NOC) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Check out our latest analysis for Northrop Grumman
The Method
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$2.55b | US$3.12b | US$3.43b | US$3.79b | US$4.07b | US$4.30b | US$4.50b | US$4.67b | US$4.83b | US$4.98b |
Growth Rate Estimate Source | Analyst x12 | Analyst x11 | Analyst x5 | Analyst x4 | Est @ 7.19% | Est @ 5.70% | Est @ 4.65% | Est @ 3.92% | Est @ 3.41% | Est @ 3.05% |
Present Value ($, Millions) Discounted @ 6.5% | US$2.4k | US$2.8k | US$2.8k | US$3.0k | US$3.0k | US$2.9k | US$2.9k | US$2.8k | US$2.7k | US$2.7k |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$28b
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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.5%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$5.0b× (1 + 2.2%) ÷ (6.5%– 2.2%) = US$120b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$120b÷ ( 1 + 6.5%)10= US$64b
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$92b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$468, the company appears a touch undervalued at a 23% 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.
Important Assumptions
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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Northrop Grumman 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 6.5%, which is based on a levered beta of 0.851. 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.
SWOT Analysis for Northrop Grumman
- Debt is well covered by earnings and cashflows.
- Dividends are covered by earnings and cash flows.
- Earnings declined over the past year.
- Dividend is low compared to the top 25% of dividend payers in the Aerospace & Defense market.
- Annual earnings are forecast to grow for the next 3 years.
- Good value based on P/E ratio and estimated fair value.
- Annual earnings are forecast to grow slower than the American market.
Moving On:
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. 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. What is the reason for the share price sitting below the intrinsic value? For Northrop Grumman, there are three relevant factors you should explore:
- Risks: To that end, you should be aware of the 1 warning sign we've spotted with Northrop Grumman .
- Future Earnings: How does NOC'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: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
Valuation is complex, but we're here to simplify it.
Discover if Northrop Grumman might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.
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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.
About NYSE:NOC
Northrop Grumman
Operates as an aerospace and defense technology company in the United States, Asia/Pacific, Europe, and internationally.
Established dividend payer with adequate balance sheet.