Today we’re going to review one way to estimate the intrinsic value of Textron Inc. (NYSE: TXT) by estimating the company’s future cash flows and discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. Anyone interested in knowing a little more about intrinsic value should read the Simply Wall St analysis model.

See our latest review for Textron

### Step by step in the calculation

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 lower growth stage. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.

In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:

#### 10-year Free Cash Flow (FCF) estimate

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Leverage FCF (\$, Millions) US \$ 979.3 million US \$ 1.02 billion US \$ 967.0 million US \$ 934.7 million US \$ 918.4 million US \$ 912.7 million US \$ 914.2 million US \$ 920.7 million US \$ 930.7 million 943.4 million US dollars Source of estimated growth rate Analyst x3 Analyst x3 Is @ -5.63% Is @ -3.34% Is @ -1.74% East @ -0.62% Is 0.16% Is @ 0.71% East @ 1.09% Est @ 1.36% Present value (in millions of dollars) discounted at 7.0% US \$ 915 US \$ 894 US \$ 788 US \$ 712 US \$ 653 US \$ 607 US \$ 568 534 USD US \$ 504 US \$ 478

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US \$ 6.7 billion

The second stage is also known as terminal value, this is the cash flow of the business after 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 of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 7.0%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US \$ 943 million × (1 + 2.0%) ÷ (7.0% – 2.0%) = US \$ 19 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= US \$ 19 billion ÷ (1 + 7.0%)ten= US \$ 9.6 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US \$ 16 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of \$ 72.7, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

### The hypotheses

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 Textron 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 takes into account debt. In this calculation, we used 7.0%, which is based on a leveraged beta of 1.071. 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.

### Looking forward:

While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Textron, we’ve compiled three other things you should consider:

1. Risks: Every company has them, and we have spotted 1 warning sign for Textron you should know.
2. Future benefits: How does TXT’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you might not have considered!

PS. Simply Wall St updates its DCF calculation for every US 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 the mentioned stocks.

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