Today we will run through one way of estimating the intrinsic value of Aristocrat Leisure Limited (ASX:ALL) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
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.
View our latest analysis for Aristocrat Leisure
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 discount the value of these future cash flows to their estimated value in today's dollars:
2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | 2034 | |
Levered FCF (A$, Millions) | AU$1.66b | AU$1.83b | AU$2.06b | AU$2.23b | AU$2.36b | AU$2.48b | AU$2.58b | AU$2.67b | AU$2.76b | AU$2.84b |
Growth Rate Estimate Source | Analyst x3 | Analyst x3 | Analyst x1 | Analyst x1 | Est @ 5.84% | Est @ 4.81% | Est @ 4.09% | Est @ 3.59% | Est @ 3.23% | Est @ 2.99% |
Present Value (A$, Millions) Discounted @ 7.1% | AU$1.6k | AU$1.6k | AU$1.7k | AU$1.7k | AU$1.7k | AU$1.6k | AU$1.6k | AU$1.5k | AU$1.5k | AU$1.4k |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$16b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.1%.
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = AU$2.8b× (1 + 2.4%) ÷ (7.1%– 2.4%) = AU$62b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$62b÷ ( 1 + 7.1%)10= AU$31b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$47b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$58.3, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. 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.
We would point out that 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 Aristocrat Leisure 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 7.1%, which is based on a levered beta of 1.143. 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 is only one of many factors that you need to assess for 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?" 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. What is the reason for the share price sitting below the intrinsic value? For Aristocrat Leisure, we've compiled three important elements you should consider:
PS. Simply Wall St updates its DCF calculation for every Australian 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. 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.