Fletcher Building Limited (NZSE:FBU) Shares Could Be 49% Below Their Intrinsic Value Estimate

Simply Wall St · 10/16 00:26

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Fletcher Building fair value estimate is NZ$6.31
  • Fletcher Building is estimated to be 49% undervalued based on current share price of NZ$3.19
  • The NZ$2.99 analyst price target for FBU is 53% 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 Fletcher Building Limited (NZSE:FBU) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Fletcher Building

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (NZ$, Millions) NZ$216.5m NZ$177.5m NZ$278.9m NZ$361.1m NZ$438.7m NZ$508.3m NZ$569.2m NZ$621.6m NZ$667.0m NZ$706.8m
Growth Rate Estimate Source Analyst x4 Analyst x5 Analyst x3 Est @ 29.48% Est @ 21.48% Est @ 15.88% Est @ 11.97% Est @ 9.22% Est @ 7.30% Est @ 5.96%
Present Value (NZ$, Millions) Discounted @ 9.7% NZ$197 NZ$148 NZ$211 NZ$250 NZ$276 NZ$292 NZ$298 NZ$297 NZ$290 NZ$281

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$2.5b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.8%. We discount the terminal cash flows to today's value at a cost of equity of 9.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = NZ$707m× (1 + 2.8%) ÷ (9.7%– 2.8%) = NZ$11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$11b÷ ( 1 + 9.7%)10= NZ$4.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$6.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of NZ$3.2, the company appears quite good value at a 49% 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
NZSE:FBU Discounted Cash Flow October 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. 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 Fletcher Building 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 9.7%, which is based on a levered beta of 1.665. 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 Fletcher Building

Strength
  • No major strengths identified for FBU.
Weakness
  • Interest payments on debt are not well covered.
  • Shareholders have been diluted in the past year.
Opportunity
  • Expected to breakeven next year.
  • Has sufficient cash runway for more than 3 years based on current free cash flows.
  • Good value based on P/S ratio and estimated fair value.
Threat
  • Debt is not well covered by operating cash flow.
  • Revenue is forecast to decrease over the next 2 years.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Fletcher Building, we've compiled three further items you should explore:

  1. Risks: As an example, we've found 2 warning signs for Fletcher Building (1 makes us a bit uncomfortable!) that you need to consider before investing here.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for FBU's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NZSE every day. If you want to find the calculation for other stocks just search here.