Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ArcBest Corporation (NASDAQ:ARCB) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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.
Step by step through the calculation
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. To start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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
|Levered FCF ($, Millions)||US$121.5m||US$113.1m||US$108.3m||US$105.7m||US$104.6m||US$104.5m||US$105.1m||US$106.1m||US$107.5m||US$109.1m|
|Growth Rate Estimate Source||Est @ -10.79%||Est @ -6.94%||Est @ -4.25%||Est @ -2.36%||Est @ -1.04%||Est @ -0.12%||Est @ 0.53%||Est @ 0.98%||Est @ 1.3%||Est @ 1.52%|
|Present Value ($, Millions) Discounted @ 7.4%||US$113||US$98.0||US$87.3||US$79.3||US$73.1||US$67.9||US$63.6||US$59.7||US$56.3||US$53.2|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$751m
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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$109m× (1 + 2.0%) ÷ (7.4%– 2.0%) = US$2.1b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.1b÷ ( 1 + 7.4%)10= US$1.0b
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$1.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$73.9, 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 ArcBest 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 7.4%, which is based on a levered beta of 1.034. 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.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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. For ArcBest, we've put together three relevant aspects you should explore:
- Risks: You should be aware of the 2 warning signs for ArcBest we've uncovered before considering an investment in the company.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ARCB's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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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This article by Simply Wall St is general in nature. 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.
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