Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Quanex Building Products Corporation (NYSE:NX) as an investment opportunity 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. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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 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) forecast
|Levered FCF ($, Millions)||US$74.8m||US$72.4m||US$71.2m||US$70.8m||US$70.9m||US$71.4m||US$72.2m||US$73.2m||US$74.4m||US$75.6m|
|Growth Rate Estimate Source||Analyst x2||Est @ -3.23%||Est @ -1.67%||Est @ -0.57%||Est @ 0.2%||Est @ 0.74%||Est @ 1.11%||Est @ 1.38%||Est @ 1.56%||Est @ 1.69%|
|Present Value ($, Millions) Discounted @ 7.8%||US$69.4||US$62.3||US$56.8||US$52.4||US$48.7||US$45.5||US$42.6||US$40.1||US$37.8||US$35.6|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$490m
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 7.8%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$76m× (1 + 2.0%) ÷ (7.8%– 2.0%) = US$1.3b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.3b÷ ( 1 + 7.8%)10= US$622m
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. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$23.5, the company appears a touch undervalued at a 29% 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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Quanex Building Products 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 7.8%, which is based on a levered beta of 1.236. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Quanex Building Products, we've compiled three essential factors you should explore:
- Risks: For instance, we've identified 1 warning sign for Quanex Building Products that you should be aware of.
- Future Earnings: How does NX'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. 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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