Does the November share price for IGO Limited (ASX: IGO) reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by estimating the company’s future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. It may sound complicated, but it’s actually quite simple!
There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you would like to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
See our latest review for IGO
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the latest estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
Generally, we assume that a dollar today is worth more 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
|Leverage FCF (A $, Millions)||A $ 377.0 million||AU $ 567.3 million||AU $ 537.5 million||AU $ 521.8 million||AUD 514.1 million||AU $ 511.7 million||512.8 million Australian dollars||AU $ 516.5 million||AU $ 521.9 million||AU $ 528.7 million|
|Source of estimated growth rate||Analyst x3||Analyst x3||Analyst x2||East @ -2.91%||Is @ -1.48%||East @ -0.48%||Is 0.22%||Is @ 0.71%||East @ 1.06%||Is 1.3%|
|Present value (A $, Millions) discounted at 6.5%||A $ 354||AU $ 500||445 AU $||405 AU $||A $ 375||AU $ 350||A $ 330||AU $ 312||AU $ 296||AU $ 281|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = AU $ 3.6 billion
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to their present value at a cost of equity of 6.5%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = AU $ 529 million × (1 + 1.9%) ÷ (6.5% to 1.9%) = AU $ 12 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= AU $ 12b ÷ (1 + 6.5%)ten= A $ 6.1 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is AU $ 9.8 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of A $ 10.2, the company appears to be slightly undervalued at a 21% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view IGO 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 takes debt into account. In this calculation, we used 6.5%, which is based on a leveraged beta of 1.064. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
While important, calculating DCF is just one of the many factors you need to assess for a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company trades at a discount to its intrinsic value? For IGO, we’ve compiled three additional factors you should consider:
- Risks: You should be aware of the 1 warning sign for IGO we found out before considering an investment in the business.
- Future benefits: How does IGO’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, just search here.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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