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Does the April share price for Sterling Construction Company, Inc. (NASDAQ:STRL) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present 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.
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. 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 are 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF ($, Millions)||$35.00||$35.00||$35.29||$35.78||$36.42||$37.18||$38.02||$38.94||$39.91||$40.94|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ 0.82%||Est @ 1.39%||Est @ 1.79%||Est @ 2.07%||Est @ 2.27%||Est @ 2.41%||Est @ 2.51%||Est @ 2.57%|
|Present Value ($, Millions) Discounted @ 9.91%||$31.84||$28.97||$26.58||$24.52||$22.70||$21.09||$19.62||$18.28||$17.05||$15.91|
Present Value of 10-year Cash Flow (PVCF)= $226.56m
"Est" = FCF growth rate estimated by Simply Wall St
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.7%) 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 9.9%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$41m × (1 + 2.7%) ÷ (9.9% – 2.7%) = US$586m
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$586m ÷ ( 1 + 9.9%)10 = $227.59m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $454.15m. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of $17.19. Relative to the current share price of $13.66, the company appears a touch undervalued at a 21% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
We would 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 these inputs, I recommend redoing the calculations yourself and playing with them. 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 Sterling Construction Company 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 9.9%, which is based on a levered beta of 1.205. 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.
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. 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. What is the reason for the share price to differ from the intrinsic value? For Sterling Construction Company, There are three further factors you should further examine:
- Financial Health: Does STRL 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 STRL'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 STRL? 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 valuation for every stock on the NASDAQ every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.