Today we will run through one way of estimating the intrinsic value of Universal Stainless & Alloy Products, Inc. (NASDAQ:USAP) 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. There's really not all that much to it, even though it might appear quite complex.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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) forecast
|Levered FCF ($, Millions)||-US$10.5m||US$6.04m||US$6.05m||US$6.10m||US$6.16m||US$6.25m||US$6.34m||US$6.44m||US$6.55m||US$6.67m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ 0.22%||Est @ 0.73%||Est @ 1.09%||Est @ 1.34%||Est @ 1.51%||Est @ 1.63%||Est @ 1.72%||Est @ 1.78%|
|Present Value ($, Millions) Discounted @ 8.7%||-US$9.7||US$5.1||US$4.7||US$4.4||US$4.1||US$3.8||US$3.5||US$3.3||US$3.1||US$2.9|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$25m
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. 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$6.7m× (1 + 1.9%) ÷ (8.7%– 1.9%) = US$101m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$101m÷ ( 1 + 8.7%)10= US$44m
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$69m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$9.1, the company appears around fair value at the time of writing. 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 Universal Stainless & Alloy 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 8.7%, which is based on a levered beta of 1.588. 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 shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. For Universal Stainless & Alloy Products, we've compiled three essential factors you should consider:
- Risks: As an example, we've found 3 warning signs for Universal Stainless & Alloy Products (2 make us uncomfortable!) that you need to consider before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for USAP's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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.
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.