I am going to run you through how I calculated the intrinsic value of W.W. Grainger, Inc. (NYSE:GWW) by taking the expected future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for W.W. Grainger by following the link below.
Crunching the numbers
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 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 forecast
|Levered FCF ($, Millions)||$999.75||$1.05k||$1.10k||$1.04k||$1.07k|
|Source||Analyst x8||Analyst x6||Analyst x4||Analyst x1||Est @ 2.6%|
|Present Value Discounted @ 10.18%||$907.34||$863.50||$818.76||$705.60||$657.03|
Present Value of 5-year Cash Flow (PVCF)= US$4.0b
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 2.9%. We discount this to today’s value at a cost of equity of 10.2%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = US$1.1b × (1 + 2.9%) ÷ (10.2% – 2.9%) = US$15b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$15b ÷ ( 1 + 10.2%)5 = US$9.4b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$13b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of $236.19. Relative to the current share price of $280.01, the stock is fair value, maybe slightly overvalued at the time of writing.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at W.W. Grainger 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 10.2%, which is based on a levered beta of 1.026. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. For GWW, I’ve put together three key factors you should further research:
- Financial Health: Does GWW 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 GWW’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 GWW? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
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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 firstname.lastname@example.org.