Today we are going to walk through one way to estimate the intrinsic value of Fresnillo plc (LON:FRES) by taking expected future cash flows and discounting them to the present value. One way to do this is to use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
See our latest analysis for Fresnillo
The method
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows 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.
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:
Estimated free cash flow (FCF) over 10 years
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF ($, millions) | $406.4 million | $429.3 million | $445.7 million | $458.8 million | $469.6 million | $478.6 million | $486.4 million | $493.2 million | $499.5 million | $505.3 million |
Growth rate estimate Source | Analyst x6 | Analyst x4 | Is at 3.81% | Is 2.95% | Is at 2.34% | Is at 1.92% | Is at 1.62% | Is at 1.41% | Is at 1.27% | Is at 1.17% |
Present value (in millions of dollars) discounted at 7.7% | $377 | $370 | $357 | $341 | $324 | $307 | $290 | $273 | $257 | $241 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $3.1 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 stage. 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 0.9%. We discount terminal cash flows to present value at a cost of equity of 7.7%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = US$505 million × (1 + 0.9%) ÷ (7.7%–0.9%) = US$7.6 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $7.6 billion ÷ (1 + 7.7%)^{ten}= $3.6 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 $6.7 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £6.9 in the UK, the company appears to be about fair value at a 17% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Important assumptions
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the 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 consider Fresnillo 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 7.7%, which is based on a leveraged beta of 1.160. 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.
Look forward:
Although a business valuation is important, it is only one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. 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. For Fresnillo, we’ve compiled three essentials you should dig deeper into:
- Risks: Take risks, for example – Fresnillo has 2 warning signs we think you should know.
- Future earnings: How does FRES’ 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 high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs an updated cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks, 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.
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