Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. For instance, while my relative valuation model tells me The Walt Disney Company’s (NYSE:DIS) is overvalued by 3.91%, my discounted cash flow (DCF) model signals a 29.55% undervaluation instead. So, which valuation methodology should I listen to and why?
Deep-dive into intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. When I discount all of DIS’s future FCFs by 11%, I obtain an equity value of $US$133b, then 1.49m shares outstanding are divided through. This results in an intrinsic value of $89.15. Take a look at how I arrived at this intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. To ensure our conclusion is robust, let’s take a look at how many analyst forecasts are being used in the last year of DIS’s 5-year forecast horizon. Given there are only 3 analyst projections of DIS’s FCF in year 5, our model highlights that it is often really difficult to accurately forecast FCFs that far out into the future. The lack of analyst forecasts undermines the conclusion we made earlier, which is a legitimate justification for attributing less weight to our DCF.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to DIS, a viable proxy would be the overall Entertainment industry itself. The calculations for relative valuation are quite simple. By multiplying DIS’s earnings by the industry’s P/E ratio, we can obtain DIS’s fair value of $120.01, which tells us that it is currently undervalued. However, should we believe this result?
To check the robustness of our relative valuation, let’s take a look at if DIS has a similar growth profile to the overall Entertainment industry. At -16.26% earnings growth next year, DIS has a dramatically different earnings growth profile to the overall Entertainment industry, which is expected to grow at 0.40%. This demonstrates that the Entertainment industry is a weak proxy for DIS, which undermines our relative valuation analysis. Rather, selectively choosing companies that had similar growth characteristics to DIS would vastly improve our conclusion. I’d encourage you to do this by taking a look at DIS’s competitors.
Which Model Is Superior?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Instead of listening to one model over another, I encourage you to calculate a weighted average target share price based off both, applying a higher weight to the valuation method you think is more appropriate.
For DIS, I’ve compiled three key factors you should further research:
- Financial Health: Does DIS have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does DIS’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: Are there other high quality stocks you could be holding instead of DIS? 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 for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.