Is Ferguson plc (NYSE:FERG) Worth US$218 Based On Its Intrinsic Value?
Key Insights
Ferguson's estimated fair value is US$163 based on 2 Stage Free Cash Flow to Equity
Ferguson's US$218 share price signals that it might be 34% overvalued
Our fair value estimate is 24% lower than Ferguson's analyst price target of US$214
Today we will run through one way of estimating the intrinsic value of Ferguson plc (NYSE:FERG) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
View our latest analysis for Ferguson
What's The Estimated Valuation?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$1.82b | US$1.84b | US$2.04b | US$2.16b | US$2.24b | US$2.31b | US$2.37b | US$2.43b | US$2.50b | US$2.56b |
Growth Rate Estimate Source | Analyst x11 | Analyst x11 | Analyst x8 | Analyst x2 | Analyst x1 | Est @ 2.99% | Est @ 2.78% | Est @ 2.63% | Est @ 2.53% | Est @ 2.46% |
Present Value ($, Millions) Discounted @ 8.5% | US$1.7k | US$1.6k | US$1.6k | US$1.6k | US$1.5k | US$1.4k | US$1.3k | US$1.3k | US$1.2k | US$1.1k |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$14b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$2.6b× (1 + 2.3%) ÷ (8.5%– 2.3%) = US$42b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$42b÷ ( 1 + 8.5%)10= US$19b
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$33b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$218, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
The 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 Ferguson 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 8.5%, which is based on a levered beta of 1.127. 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 Ferguson
Strength
Debt is well covered by earnings and cashflows.
Dividends are covered by earnings and cash flows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Trade Distributors market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Good value based on P/E ratio compared to estimated Fair P/E ratio.
Threat
Annual earnings are forecast to grow slower than the American market.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. 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. Can we work out why the company is trading at a premium to intrinsic value? For Ferguson, we've compiled three relevant items you should further examine:
Risks: Take risks, for example - Ferguson has 1 warning sign we think you should be aware of.
Future Earnings: How does FERG'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 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 NYSE 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.
