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Are Investors Undervaluing Wabtec Corporation (NYSE:WAB) By 43%?

Simply Wall St
·6 min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Wabtec Corporation (NYSE:WAB) as an investment opportunity by projecting its future cash flows and then 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.

See our latest analysis for Wabtec

The 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 start off with, we need to estimate 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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF ($, Millions)

US$1.05b

US$1.23b

US$1.47b

US$1.64b

US$1.79b

US$1.91b

US$2.01b

US$2.10b

US$2.17b

US$2.23b

Growth Rate Estimate Source

Analyst x3

Analyst x2

Analyst x1

Est @ 11.96%

Est @ 8.89%

Est @ 6.75%

Est @ 5.25%

Est @ 4.19%

Est @ 3.46%

Est @ 2.94%

Present Value ($, Millions) Discounted @ 8.5%

US$964

US$1.0k

US$1.2k

US$1.2k

US$1.2k

US$1.2k

US$1.1k

US$1.1k

US$1.0k

US$991

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$11b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$2.2b× (1 + 1.7%) ÷ 8.5%– 1.7%) = US$34b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$34b÷ ( 1 + 8.5%)10= US$15b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$26b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$77.0, the company appears quite good value at a 43% 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.

NYSE:WAB Intrinsic value, January 31st 2020
NYSE:WAB Intrinsic value, January 31st 2020

The 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 Wabtec 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 8.5%, which is based on a levered beta of 1.236. 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:

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 Wabtec, I've compiled three pertinent factors you should look at:

  1. Financial Health: Does WAB 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 WAB'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 WAB? 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.

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.

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. Thank you for reading.