In this article I am going to calculate the intrinsic value of Sterling Construction Company Inc (NASDAQ:STRL) by estimating the company’s future cash flows and discounting them to their present value. I will be 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. Please also note that this article was written in September 2018 so be sure check out the updated calculation by following the link below.
What’s the value?
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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF ($, Millions)||$35.00||$39.10||$43.67||$48.78||$54.49|
|Source||Analyst x1||Est @ 11.7%||Est @ 11.7%||Est @ 11.7%||Est @ 11.7%|
|Present Value Discounted @ 9.86%||$31.86||$32.39||$32.94||$33.49||$34.05|
Present Value of 5-year Cash Flow (PVCF)= US$164.7m
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond 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 9.9%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$54.5m × (1 + 2.9%) ÷ (9.9% – 2.9%) = US$811.9m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$811.9m ÷ ( 1 + 9.9%)5 = US$507.3m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$672.0m. In the final step we 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) or ADR then we use the equivalent number. This results in an intrinsic value of $24.83. Compared to the current share price of $14.55, the stock is quite good value at a 41.4% discount to what it is available for right now.
Now 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 Sterling Construction Company 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 9.9%, which is based on a levered beta of 0.980. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For STRL, I’ve put together three essential factors you should further research:
- Financial Health: Does STRL 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 STRL’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 STRL? 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 email@example.com.