Stock Analysis

# Calculating The Intrinsic Value Of Advanced Drainage Systems, Inc. (NYSE:WMS)

In this article we are going to estimate the intrinsic value of Advanced Drainage Systems, Inc. (NYSE:WMS) by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

See our latest analysis for Advanced Drainage Systems

## What's The Estimated Valuation?

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. 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.

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) estimate

 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (\$, Millions) US\$609.6m US\$587.7m US\$577.7m US\$574.6m US\$576.0m US\$580.3m US\$586.8m US\$594.9m US\$604.2m US\$614.4m Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Est @ -0.52% Est @ 0.23% Est @ 0.75% Est @ 1.12% Est @ 1.38% Est @ 1.56% Est @ 1.69% Present Value (\$, Millions) Discounted @ 8.3% US\$563 US\$501 US\$454 US\$417 US\$386 US\$359 US\$335 US\$313 US\$294 US\$276

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US\$3.9b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (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 8.3%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US\$614m× (1 + 2.0%) ÷ (8.3%– 2.0%) = US\$9.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US\$9.8b÷ ( 1 + 8.3%)10= US\$4.4b

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\$8.3b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US\$85.6, the company appears about fair value at a 15% 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.

## 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 Advanced Drainage Systems 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 8.3%, which is based on a levered beta of 1.143. 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 Advanced Drainage Systems

Strength
• Earnings growth over the past year exceeded the industry.
• Debt is well covered by earnings and cashflows.
Weakness
• Dividend is low compared to the top 25% of dividend payers in the Building market.
• Shareholders have been diluted in the past year.
Opportunity
• Annual earnings are forecast to grow for the next 3 years.
• Good value based on P/E ratio and estimated fair value.
Threat
• Annual earnings are forecast to grow slower than the American market.

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. DCF models are not the be-all and end-all of investment valuation. 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. For Advanced Drainage Systems, we've compiled three essential items you should further examine:

1. Risks: To that end, you should be aware of the 3 warning signs we've spotted with Advanced Drainage Systems .
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for WMS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. 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.

### New: Manage All Your Stock Portfolios in One Place

We've created the ultimate portfolio companion for stock investors, and it's free.

• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.