Stock Analysis

Are Investors Undervaluing First Advantage Corporation (NASDAQ:FA) By 47%?

NasdaqGS:FA
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Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, First Advantage fair value estimate is US$37.15
  • First Advantage is estimated to be 47% undervalued based on current share price of US$19.56
  • The US$20.00 analyst price target for FA is 46% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of First Advantage Corporation (NASDAQ:FA) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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 First Advantage

Step By Step Through The Calculation

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$183.1m US$200.0m US$212.9m US$224.1m US$234.0m US$243.1m US$251.4m US$259.4m US$267.1m US$274.6m
Growth Rate Estimate Source Analyst x3 Analyst x1 Est @ 6.45% Est @ 5.26% Est @ 4.43% Est @ 3.85% Est @ 3.45% Est @ 3.16% Est @ 2.96% Est @ 2.83%
Present Value ($, Millions) Discounted @ 6.5% US$172 US$176 US$176 US$174 US$171 US$167 US$162 US$157 US$152 US$146

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.7b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.5%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$275m× (1 + 2.5%) ÷ (6.5%– 2.5%) = US$7.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$7.0b÷ ( 1 + 6.5%)10= US$3.7b

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$5.4b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$19.6, the company appears quite good value at a 47% 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
NasdaqGS:FA Discounted Cash Flow September 16th 2024

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 First Advantage 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 0.971. 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 First Advantage

Strength
  • Debt is well covered by cash flow.
Weakness
  • Earnings declined over the past year.
  • Interest payments on debt are not well covered.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Annual revenue is 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 is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For First Advantage, we've compiled three further factors you should explore:

  1. Risks: We feel that you should assess the 2 warning signs for First Advantage we've flagged before making an investment in the company.
  2. Future Earnings: How does FA'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.
  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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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.