Today we will run through one way of estimating the intrinsic value of Allied Farmers Limited (NZSE:ALF) by taking the expected future cash flows and discounting them to today's value. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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 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.
Is Allied Farmers 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 begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (NZ$, Millions)||NZ$676.7k||NZ$639.6k||NZ$620.1k||NZ$611.7k||NZ$610.7k||NZ$614.7k||NZ$622.4k||NZ$632.7k||NZ$644.9k||NZ$658.7k|
|Growth Rate Estimate Source||Est @ -8.93%||Est @ -5.47%||Est @ -3.05%||Est @ -1.36%||Est @ -0.17%||Est @ 0.66%||Est @ 1.24%||Est @ 1.65%||Est @ 1.94%||Est @ 2.13%|
|Present Value (NZ$, Millions) Discounted @ 7.7%||NZ$0.6||NZ$0.6||NZ$0.5||NZ$0.5||NZ$0.4||NZ$0.4||NZ$0.4||NZ$0.4||NZ$0.3||NZ$0.3|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$4.0m
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 10-year government bond rate (2.6%) 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 7.7%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = NZ$659k× (1 + 2.6%) ÷ 7.7%– 2.6%) = NZ$13m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$13m÷ ( 1 + 7.7%)10= NZ$6.4m
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 NZ$10m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$0.6, 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Allied Farmers 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 7.7%, which is based on a levered beta of 0.845. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. For Allied Farmers, We've put together three essential aspects you should further examine:
- Risks: For example, we've discovered 4 warning signs for Allied Farmers (2 make us uncomfortable!) that you should be aware of before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ALF's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every NZ 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. 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. Thank you for reading.