I am going to run you through how I calculated the intrinsic value of Incitec Pivot Limited (ASX:IPL) by taking the expected future cash flows and discounting them 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. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in December 2018 so be sure check out the updated calculation by following the link below.
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. In the first stage we need to estimate the cash flows to the business over the next five years. 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 (A$, Millions)||A$565.67||A$563.33||A$545.50||A$552.38||A$559.34|
|Source||Analyst x3||Analyst x3||Analyst x2||Est @ 1.26%||Est @ 1.26%|
|Present Value Discounted @ 8.55%||A$521.09||A$478.04||A$426.43||A$397.78||A$371.05|
Present Value of 5-year Cash Flow (PVCF)= AU$2.2b
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 2.8%. We discount this to today’s value at a cost of equity of 8.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = AU$559m × (1 + 2.8%) ÷ (8.6% – 2.8%) = AU$9.9b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$9.9b ÷ ( 1 + 8.6%)5 = AU$6.6b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$8.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of A$5.45. Compared to the current share price of A$3.48, the stock is quite undervalued at a 36% 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. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Incitec Pivot 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 8.6%, which is based on a levered beta of 0.800. 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.
Whilst important, DCF calculation 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 IPL, I’ve compiled three pertinent factors you should further examine:
- Financial Health: Does IPL 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 IPL’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 IPL? 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 ASX every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.