Today we are going to take a simple overview of a valuation method used to estimate the attractiveness of Veritiv Corporation (NYSE: VRTV) as an investment opportunity by taking forecasted future cash flows. of the company and discounting them to their current value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
We would like to point out that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. For those who are thoroughly learning about equity analysis, the Simply Wall St analysis template here may interest you.
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We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Since no analysts estimate of free cash flow is available to us, we have extrapolated past free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, million)||140.3 million USD||115.6 million USD||$ 102.0 million||$ 94.2 million||89.7 million USD||$ 87.3 million||86.2 million USD||$ 85.9 million||86.2 million USD||86.9 million USD|
|Source of estimated growth rate||Is @ -26.04%||Is at -17.63%||Is @ -11.75%||Is at -7.63%||Is at -4.74%||Is at -2.72%||Is at -1.31%||East @ -0.32%||Is 0.37%||Is 0.86%|
|Present value ($, millions) discount at 10%||US $ 127||US $ 95.3||$ 76.4||US $ 64.1||US $ 55.5||$ 49.0||$ 43.9||$ 39.8||US $ 36.3||$ 33.2|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 621 million USD
The second stage is also known as terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 10%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US $ 87 million × (1 + 2.0%) ÷ (10% – 2.0%) = US $ 1.1 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $ 1.1 billion ÷ (1 + 10%)ten= 418 million USD
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is US $ 1.0 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of US $ 61.4, the company appears to have fair value at a 7.4% discount from the current share price. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play with the 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 complete picture of a company’s potential performance. Since we view Veritiv 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 10%, which is based on a leveraged beta of 1.717. 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 of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
While important, the DCF calculation ideally won’t be the only analysis you will look at for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see how they would impact 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 Veritiv, we have put together three essential aspects to take into account:
- Risks: For example, we have identified 3 warning signs for Veritiv that you need to be aware of.
- Future income: How does VRTV’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come 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 inventory to get a feel for what you might be missing!
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.
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