Aurizon Holdings Limited (ASX:AZJ) Shares Could Be 27% Below Their Intrinsic Value Estimate

Key Insights

• Aurizon Holdings' estimated fair value is AU$4.95 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$3.60 suggests Aurizon Holdings is potentially 27% undervalued

• Our fair value estimate is 26% higher than Aurizon Holdings' analyst price target of AU$3.92

How far off is Aurizon Holdings Limited (ASX:AZJ) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Aurizon Holdings

Is Aurizon Holdings Fairly Valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$483.7m	AU$478.9m	AU$536.8m	AU$636.0m	AU$664.5m	AU$687.4m	AU$708.3m	AU$727.7m	AU$746.3m	AU$764.3m
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x5	Analyst x2	Analyst x2	Est @ 3.45%	Est @ 3.04%	Est @ 2.75%	Est @ 2.55%	Est @ 2.41%
Present Value (A$, Millions) Discounted @ 8.7%	AU$445	AU$405	AU$418	AU$455	AU$437	AU$416	AU$394	AU$373	AU$352	AU$331

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$4.0b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$764m× (1 + 2.1%) ÷ (8.7%– 2.1%) = AU$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$12b÷ ( 1 + 8.7%)¹⁰= AU$5.1b

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$9.1b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$3.6, the company appears a touch undervalued at a 27% 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

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Aurizon Holdings 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 8.7%, which is based on a levered beta of 1.328. 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 Aurizon Holdings

Strength

• Debt is well covered by earnings.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Transportation market.

Opportunity

• Annual earnings are forecast to grow faster than the Australian market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Aurizon Holdings, we've put together three additional items you should explore:

1. Risks: For example, we've discovered 3 warning signs for Aurizon Holdings (1 is potentially serious!) that you should be aware of before investing here.

2. Future Earnings: How does AZJ'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 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. 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.