How far off is Arrow Electronics, Inc. (NYSE:ARW) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by taking the foreast future cash flows of the company and discounting them back to today’s value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not December 2018 then I highly recommend you check out the latest calculation for Arrow Electronics by following the link below.
Crunching the numbers
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 begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
|Levered FCF ($, Millions)||$871.43||$1.10k||$782.00||$722.00||$765.64|
|Source||Analyst x2||Analyst x1||Analyst x1||Analyst x1||Est @ 6.04%|
|Present Value Discounted @ 13.58%||$767.25||$851.93||$533.72||$433.86||$405.08|
Present Value of 5-year Cash Flow (PVCF)= US$3.0b
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 the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 13.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$766m × (1 + 2.9%) ÷ (13.6% – 2.9%) = US$7.4b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$7.4b ÷ ( 1 + 13.6%)5 = US$3.9b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$6.9b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $79.33. Compared to the current share price of $70.41, the stock is about right, perhaps slightly undervalued at a 11% discount to what it is available for right now.
I’d like to 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Arrow Electronics as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 13.6%, which is based on a levered beta of 1.508. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. For ARW, there are three pertinent factors you should further research:
- Financial Health: Does ARW have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does ARW’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of ARW? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.
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The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.