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Are Investors Undervaluing Federal Signal Corporation (NYSE:FSS) By 21%?

Simply Wall St

Does the April share price for Federal Signal Corporation (NYSE:FSS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

View our latest analysis for Federal Signal

The method

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 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) estimate

2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
Levered FCF ($, Millions) US$77.5 US$128 US$136 US$146 US$153 US$159 US$165 US$171 US$177 US$182
Growth Rate Estimate Source Analyst x3 Analyst x3 Analyst x1 Analyst x1 Analyst x1 Est @ 4.19% Est @ 3.76% Est @ 3.45% Est @ 3.23% Est @ 3.08%
Present Value ($, Millions) Discounted @ 9.4% US$70.8 US$107 US$104 US$102 US$97.6 US$93.0 US$88.2 US$83.4 US$78.7 US$74.2

Present Value of 10-year Cash Flow (PVCF)= $898.62m

"Est" = FCF growth rate estimated by Simply Wall St

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$182m × (1 + 2.7%) ÷ (9.4% – 2.7%) = US$2.8b

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$2.8b ÷ ( 1 + 9.4%)10 = $1.14b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $2.04b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of $33.87. Relative to the current share price of $26.82, the company appears a touch undervalued at a 21% discount to what it is available for right now. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

NYSE:FSS Intrinsic value, April 16th 2019

The assumptions

Now 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 Federal Signal 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 9.4%, which is based on a levered beta of 1.119. 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.

Next Steps:

Although the valuation of a company is important, 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 Federal Signal, I've compiled three further aspects you should further research:

  1. Financial Health: Does FSS 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.
  2. Future Earnings: How does FSS'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.
  3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of FSS? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock 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 editorial-team@simplywallst.com. 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.