Two Ways Of Valuing Eastman Chemical Company’s (NYSE:EMN) Stock
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Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. For instance, while my relative valuation model tells me Eastman Chemical Company’s (NYSE:EMN) is overvalued by 119.96%, my discounted cash flow (DCF) model signals a 6.21% undervaluation instead. Which model do I listen to and more importantly why?
Check out our latest analysis for Eastman Chemical
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. When I discount all of EMN’s future FCFs by 13%, I obtain an equity value of $US$11b, then 139.80k shares outstanding are divided through. This results in an intrinsic value of $79.65. 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. 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. EMN’s final year FCF growth rate of -10.86%, is too low. If this assumption held true, EMN would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. The downside is that forecasts are less reliable the further into the future they are.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to EMN, a viable proxy would be the overall Chemicals industry itself. The calculations for relative valuation are quite simple. By multiplying EMN’s earnings by the industry’s P/E ratio, we can obtain EMN’s fair value of $186.08, which tells us that it is currently undervalued. However, should we believe this result?
To check the robustness of our relative valuation, let’s take a look at if EMN has a similar growth profile to the overall Chemicals industry. At 13.65% earnings growth next year, EMN has a dramatically different earnings growth profile to the overall Chemicals industry, which is expected to grow at 23.99%. This demonstrates that the Chemicals industry is a weak proxy for EMN, which undermines our relative valuation analysis. Rather, selectively choosing companies that had similar growth characteristics to EMN would vastly improve our conclusion. I’d encourage you to do this by taking a look at EMN’s competitors.
What Model Should I Listen To?
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.
Next Steps:
For EMN, I’ve put together three pertinent aspects you should further examine:
Financial Health: Does EMN 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 EMN’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 EMN? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
