Today we’re going to review one way to estimate the intrinsic value of Israel Corporation Ltd (TLV: ILCO) by taking expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
See our latest analysis for Israel
What is the estimated valuation?
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. To begin with, we need to estimate the next ten years of cash flow. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 329.4 million||US $ 299.9 million||282.5 million US dollars||US $ 272.4 million||US $ 266.8 million||US $ 264.2 million||US $ 263.7 million||US $ 264.6 million||$ 266.4 million||$ 268.9 million|
|Source of estimated growth rate||Is @ -13.45%||Is @ -8.95%||Is @ -5.8%||Is @ -3.59%||East @ -2.04%||East @ -0.96%||East @ -0.21%||Is @ 0.32%||East @ 0.69%||Is @ 0.95%|
|Present value (in millions of dollars) discounted at 11%||US $ 297||US $ 244||$ 207||180 USD||US $ 159||$ 142||128 USD||116 USD||105 USD||US $ 96.1|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 1.7 billion
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.6%. We discount terminal cash flows to their present value at a cost of equity of 11%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = US $ 269 million Ã (1 + 1.6%) Ã· (11% to 1.6%) = US $ 2.9 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 2.9b Ã· (1 + 11%)ten= US $ 1.1 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 2.7 billion. In the last step, we divide the equity value by the number of shares outstanding. From the current stock price of 1.0k âª, the company appears to be roughly at fair value with a 10.0% discount from where the stock price is currently trading. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Israel as a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 11%, which is based on a leveraged beta of 1.868. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect equity valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Israel, we’ve put together three other factors that you should take a closer look at:
- Risks: Know that Israel shows 3 warning signs in our investment analysis , and 1 of them is significant …
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
- Other environmentally friendly companies: Are you concerned about the environment and think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover stocks you may not have thought of!
PS. Simply Wall St updates its DCF calculation for every Israeli stock every day, so if you want to find the intrinsic value of any other stock just search here.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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