Is There An Opportunity With Lamb Weston Holdings, Inc.'s (NYSE:LW) 29% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Lamb Weston Holdings fair value estimate is US$150

• Lamb Weston Holdings is estimated to be 29% undervalued based on current share price of US$106

• Our fair value estimate is 17% higher than Lamb Weston Holdings' analyst price target of US$128

In this article we are going to estimate the intrinsic value of Lamb Weston Holdings, Inc. (NYSE:LW) by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Lamb Weston Holdings

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$115.9m	US$392.7m	US$467.1m	US$708.0m	US$833.0m	US$925.4m	US$1.00b	US$1.07b	US$1.13b	US$1.17b
Growth Rate Estimate Source	Analyst x3	Analyst x4	Analyst x3	Analyst x1	Analyst x1	Est @ 11.09%	Est @ 8.43%	Est @ 6.57%	Est @ 5.26%	Est @ 4.35%
Present Value ($, Millions) Discounted @ 6.2%	US$109	US$348	US$390	US$556	US$616	US$644	US$658	US$660	US$654	US$642

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.3b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.2%) 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 6.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$1.2b× (1 + 2.2%) ÷ (6.2%– 2.2%) = US$30b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$30b÷ ( 1 + 6.2%)¹⁰= US$16b

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$22b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$106, the company appears a touch undervalued at a 29% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Lamb Weston Holdings 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 6.2%, which is based on a levered beta of 0.800. 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 Lamb Weston Holdings

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Food market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

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

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Lamb Weston Holdings, we've compiled three pertinent aspects you should look at:

1. Risks: For example, we've discovered 2 warning signs for Lamb Weston Holdings (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

2. Future Earnings: How does LW'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 American 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.