Are Investors Undervaluing Vulcan Steel Limited (ASX:VSL) By 24%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Vulcan Steel fair value estimate is AU$10.16

• Vulcan Steel is estimated to be 24% undervalued based on current share price of AU$7.71

• The NZ$8.36 analyst price target for VSL is 18% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Vulcan Steel Limited (ASX:VSL) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Vulcan Steel

The Model

We're 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 a stable growth rate. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (NZ$, Millions)	NZ$87.9m	NZ$77.9m	NZ$118.3m	NZ$115.8m	NZ$114.9m	NZ$114.9m	NZ$115.7m	NZ$116.9m	NZ$118.6m	NZ$120.4m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -2.07%	Est @ -0.83%	Est @ 0.04%	Est @ 0.66%	Est @ 1.08%	Est @ 1.38%	Est @ 1.59%
Present Value (NZ$, Millions) Discounted @ 9.0%	NZ$80.6	NZ$65.6	NZ$91.4	NZ$82.1	NZ$74.7	NZ$68.6	NZ$63.3	NZ$58.7	NZ$54.6	NZ$50.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$691m

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 5-year average of the 10-year government bond yield (2.1%) 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 9.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NZ$120m× (1 + 2.1%) ÷ (9.0%– 2.1%) = NZ$1.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$1.8b÷ ( 1 + 9.0%)¹⁰= NZ$752m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$1.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$7.7, the company appears a touch undervalued at a 24% 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.

ASX:VSL Discounted Cash Flow December 28th 2023

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Vulcan Steel 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 9.0%, which is based on a levered beta of 1.382. 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 Vulcan Steel

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 Metals and Mining market.

Opportunity

• Annual earnings are forecast to grow faster than the Australian market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual revenue is forecast to grow slower than the Australian market.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Vulcan Steel, we've put together three relevant factors you should explore:

1. Risks: For example, we've discovered 3 warning signs for Vulcan Steel that you should be aware of before investing here.

2. Future Earnings: How does VSL'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 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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock 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.