Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Hexcel Corporation (NYSE:HXL) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today’s value. I will use 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 June 2018 then I highly recommend you check out the latest calculation for Hexcel by following the link below. Check out our latest analysis for Hexcel
Crunching the numbers
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow estimate
|Levered FCF ($, Millions)||$240.05||$269.75||$311.67||$324.75||$338.37|
|Source||Analyst x8||Analyst x6||Analyst x3||Extrapolated @ (4.2%)||Extrapolated @ (4.2%)|
|Present Value Discounted @ 9.78%||$218.66||$223.81||$235.54||$223.56||$212.18|
Present Value of 5-year Cash Flow (PVCF)= US$1.11b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 9.8%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$338.37m × (1 + 2.9%) ÷ (9.8% – 2.9%) = US$5.10b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$5.10b ÷ ( 1 + 9.8%)5 = US$3.20b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$4.31b. The last step is to then 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) then we use the equivalent number. This results in an intrinsic value of $48.17. Compared to the current share price of $68.8, the stock is quite expensive at the time of writing.
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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Hexcel 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 9.8%, which is based on a levered beta of 0.969. 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. What is the reason for the share price to differ from the intrinsic value? For HXL, there are three key aspects you should further examine:
- Financial Health: Does HXL 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 HXL’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 HXL? 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.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.