Norfolk Southern Corporation (NYSE:NSC) Shares Could Be 34% Above Their Intrinsic Value Estimate

By
Simply Wall St
Published
January 11, 2022
NYSE:NSC
Source: Shutterstock

In this article we are going to estimate the intrinsic value of Norfolk Southern Corporation (NYSE:NSC) by projecting its future cash flows and then discounting them to today's 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. 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.

View our latest analysis for Norfolk Southern

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. To begin with, we have to get estimates of the next ten years of cash flows. 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) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$2.86b US$3.05b US$3.05b US$2.91b US$2.84b US$2.81b US$2.81b US$2.82b US$2.85b US$2.88b
Growth Rate Estimate Source Analyst x9 Analyst x6 Analyst x2 Analyst x1 Est @ -2.38% Est @ -1.08% Est @ -0.17% Est @ 0.47% Est @ 0.92% Est @ 1.23%
Present Value ($, Millions) Discounted @ 6.8% US$2.7k US$2.7k US$2.5k US$2.2k US$2.0k US$1.9k US$1.8k US$1.7k US$1.6k US$1.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$21b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$2.9b× (1 + 2.0%) ÷ (6.8%– 2.0%) = US$61b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$61b÷ ( 1 + 6.8%)10= US$32b

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$52b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$288, the company appears potentially overvalued at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
NYSE:NSC Discounted Cash Flow January 11th 2022

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Norfolk Southern 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 6.8%, which is based on a levered beta of 1.101. 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.

Next Steps:

Whilst important, the DCF calculation 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. What is the reason for the share price exceeding the intrinsic value? For Norfolk Southern, there are three essential elements you should explore:

  1. Risks: As an example, we've found 1 warning sign for Norfolk Southern that you need to consider before investing here.
  2. Future Earnings: How does NSC'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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