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
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:
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.
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.
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:
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.
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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.