Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. For example, we can either look at The Toro Company’s (NYSE:TTC) cash flows or its peer group’s valuation to decide how much the company is actually worth. 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 TTC’s future FCFs by 10%, it’s equity value comes to $US$5.0b, then 105.19k shares outstanding are divided through. This results in an intrinsic value of $47.6. Check out the source of my intrinsic value here.,
But how accurate is this figure? Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. TTC’s final year FCF growth rate of -2.88%, is too low. If this assumption held true, TTC 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 basic principle of relative valuation is that two companies with near identical characteristics should be priced similarly. But a big issue here is actually finding companies that are similar to TTC, so I’ve used the Machinery industry as a proxy. Obtaining the fair value of TTC through relative valuation is quite straightforward. We simply multiply TTC’s earnings by the industry’s P/E ratio, which gives us a share price of $47.95 that implies TTC is currently overvalued. However, is this conclusion robust enough for us to use?
One quick way of finding out is to see if TTC shares a similar growth profile to the overall Machinery industry we are comparing it to. With a projected earnings growth rate of 16.12% for next year, TTC has a significantly different growth profile when compared with the Machinery industry, which is projected to grow at 28.53%. Unfortunately, this check shows that the Machinery industry is a poor proxy for TTC, which weakens our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with TTC. I’d encourage you to do this by taking a look at TTC’s competitors.
Which Model Should I Care About?
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. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
For TTC, I’ve compiled three pertinent aspects you should further research:
- Financial Health: Does TTC 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 TTC’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 TTC? 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.