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A Look At The Fair Value Of Orica Limited (ASX:ORI)

Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Orica Limited (ASX:ORI) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. This is done using 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. If you are reading this and its not December 2018 then I highly recommend you check out the latest calculation for Orica by following the link below.

Check out our latest analysis for Orica

The calculation

I’m 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 perpetual stable growth rate. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow estimate

2019 2020 2021 2022 2023
Levered FCF (A$, Millions) A$520.00 A$423.00 A$535.00 A$506.75 A$480.00
Source Analyst x1 Analyst x2 Analyst x1 Est @ -5.28% Est @ -5.28%
Present Value Discounted @ 8.55% A$479.02 A$358.96 A$418.22 A$364.92 A$318.42

Present Value of 5-year Cash Flow (PVCF)= AU$1.9b

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 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$480m × (1 + 2.8%) ÷ (8.6% – 2.8%) = AU$8.5b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$8.5b ÷ ( 1 + 8.6%)5 = AU$5.7b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$7.6b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of A$20.04. Relative to the current share price of A$17.5, the stock is about right, perhaps slightly undervalued at a 13% discount to what it is available for right now.

ASX:ORI Intrinsic Value Export December 3rd 18

Important assumptions

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. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Orica 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.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For ORI, I’ve put together three pertinent factors you should further research:

  1. Financial Health: Does ORI 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 ORI’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 ORI? 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 editorial-team@simplywallst.com.