With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. For instance, while my relative valuation model tells me James Hardie Industries plc’s (ASX:JHX) is overvalued by 42.92%, my discounted cash flow (DCF) model signals a 177.12% overvaluation instead. So, which valuation methodology should I listen to and why?
A closer look at intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. After discounting the sum of JHX’s future FCFs by 8.55%, it’s equity value comes to A$3.64B. After dividing this by 441.52M shares outstanding, we get a target share price of A$8.25. This means that broker analysts think JHX is currently trading above its true value at A$22.87. Take a look at how I arrived at this 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. JHX’s final year FCF growth rate of -0.13%, is too low. If this assumption held true, JHX 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%. However, the trade-off is that there are less analyst forecasts the further in the future 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 JHX to compare it against. As such, I’ve used the overall Basic Materials industry as JHX’s proxy. To calculate the “true” value of JHX, we multiply JHX’s earnings by the industry’s P/E ratio to obtain a share price of A$13.05, which means JHX is overvalued. But is this a dependable conclusion?
To check the robustness of our relative valuation, let’s take a look at if JHX has a similar growth profile to the overall Basic Materials industry. With a projected earnings growth rate of 23.68% for next year, JHX has a significantly different growth profile when compared with the Basic Materials industry, which is projected to grow at 16.02%. This demonstrates that the Basic Materials industry is a weak proxy for JHX, which undermines our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with JHX. I’d encourage you to do this by taking a look at JHX’s competitors.
Which Model Should I Care About?
Neither model is perfect despite the robust financial theory behind them. Relative valuation is straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Instead of listening to one model over another, I encourage you to calculate a weighted average target share price based off both, applying a higher weight to the valuation method you think is more appropriate.
For JHX, I’ve put together three essential factors you should further examine:
- Financial Health: Does JHX 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 JHX’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 JHX? 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 ASX every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see pass 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.