Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. For instance, while my relative valuation model tells me Hexcel Corporation’s (NYSE:HXL) is overvalued by 0.65%, my discounted cash flow (DCF) model signals a 18.29% overvaluation instead. So, which model is more reliable and why?
Deep-dive into intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. After discounting the sum of HXL’s future FCFs by 10%, it’s equity value comes to $US$4.5b, then 86.10k shares outstanding are divided through. This results in an intrinsic value of $52.32. Take a look at how I arrived at this intrinsic value here.,
Before we accept this value and move on, let’s take a look at how reliable it is. A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in HXL’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. At -5.36%, final year FCF growth is unsustainably low. If this assumption held true, HXL would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. But investors also have to be mindful that there are far less data points the further out we go.
A closer look at relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to HXL to compare it against. As such, I’ve used the overall Aerospace & Defense industry as HXL’s proxy. Obtaining the fair value of HXL through relative valuation is quite straightforward. We simply multiply HXL’s earnings by the industry’s P/E ratio, which gives us a share price of $61.49 that implies HXL is currently overvalued. However, is this conclusion robust enough for us to use?
One quick way of finding out is to see if HXL shares a similar capital structure to the overall Aerospace & Defense industry we are comparing it to. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. At 72.41, HXL’s D/E ratio is significantly higher than the average firm in the Aerospace & Defense industry, which has a D/E ratio of 98.77%. In this case, rather than using a price multiple like P/E, we could resolve this issue by using an enterprise multiple like EV/EBITDA, which is immune from being influenced by differing capital structures.
Which Model Is Superior?
Neither model is perfect despite the robust financial theory behind them. While intrinsic valuation is immune from market irrationality and mispricing, it is highly exposed to forecasting error. On the other hand, relative valuation is easy to calculate but affected by overall market mispricing. For example, relative valuation would not have been an effective tool to value a technology company at the height of the dotcom bubble in 2000. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For HXL, I’ve compiled three fundamental factors you should look at:
- Financial Health: Does HXL 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 HXL’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 HXL? 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.
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 email@example.com.