Calculating The Fair Value Of AAON, Inc. (NASDAQ:AAON)

Key Insights

• AAON's estimated fair value is US$88.48 based on 2 Stage Free Cash Flow to Equity

• With US$98.00 share price, AAON appears to be trading close to its estimated fair value

• Analyst price target for AAON is US$109, which is 24% above our fair value estimate

How far off is AAON, Inc. (NASDAQ:AAON) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for AAON

The Model

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$102.1m	US$151.4m	US$203.7m	US$254.1m	US$299.8m	US$339.4m	US$373.0m	US$401.2m	US$424.9m	US$445.2m
Growth Rate Estimate Source	Analyst x1	Est @ 48.37%	Est @ 34.49%	Est @ 24.78%	Est @ 17.98%	Est @ 13.22%	Est @ 9.89%	Est @ 7.55%	Est @ 5.92%	Est @ 4.78%
Present Value ($, Millions) Discounted @ 8.7%	US$93.9	US$128	US$159	US$182	US$198	US$206	US$209	US$206	US$201	US$194

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.8b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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) = US$445m× (1 + 2.1%) ÷ (8.7%– 2.1%) = US$6.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$6.9b÷ ( 1 + 8.7%)¹⁰= US$3.0b

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 US$4.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$98.0, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

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 AAON 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 1.103. 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 AAON

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

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

• Expensive based on P/E ratio and estimated fair value.

• Shareholders have been diluted in the past year.

Opportunity

• Annual revenue is forecast to grow faster than the American market.

Threat

• Annual earnings are forecast to grow slower than the American market.

Moving On:

Whilst important, the DCF calculation 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For AAON, we've put together three pertinent elements you should look at:

1. Risks: Every company has them, and we've spotted 1 warning sign for AAON you should know about.

2. Future Earnings: How does AAON'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS 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.