Today we’re going to walk through one way to estimate the intrinsic value of Arconic Corporation (NYSE:ARNC) by taking expected future cash flows and discounting them to the present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. This may sound complicated, but it’s actually quite simple!
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.
See our latest analysis for Arconic
Step by step in the calculation
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. 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 more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$403.3 million||$596.3 million||$659.5 million||$573.0 million||$524.5 million||$496.6 million||$481.0 million||$473.2 million||$470.6 million||$471.6 million|
|Growth rate estimate Source||Analyst x4||Analyst x4||Analyst x2||Analyst x1||Is @ -8.46%||Is @ -5.33%||Is @ -3.14%||Is @ -1.61%||East @ -0.54%||Is at 0.21%|
|Present value (millions of dollars) discounted at 7.9%||$374||$512||$525||$423||$359||$315||$283||$258||$238||$221|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $3.5 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 7.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$472 million × (1 + 2.0%) ÷ (7.9%–2.0%) = US$8.1 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $8.1 billion ÷ (1 + 7.9%)ten= $3.8 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $7.3 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of US$34.9, the company appears to be pretty good value at a 49% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the 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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Arconic as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which factors in debt. In this calculation, we used 7.9%, which is based on a leveraged beta of 1.353. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Can we understand why the company is trading at a discount to its intrinsic value? For Arconic, we have compiled three relevant items that you should consider in more detail:
- Risks: For example, we discovered 1 warning sign for Arconic which you should be aware of before investing here.
- Future earnings: How does ARNC’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.