Today we are going to review a valuation method used to estimate the attractiveness of Nick Scali Limited (ASX: NCK) as an investment opportunity by taking expected future cash flows and discounting them at their current 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 will see in our example!

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in knowing a little more about intrinsic value should read the Simply Wall St analysis model.

See our latest analysis for Nick Scali

### The method

We are going to use a two-step 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 “steady growth”. To begin with, we need to get cash flow estimates for 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.

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 those future cash flows is then discounted to today’s value. :

#### 10-year free cash flow (FCF) forecast

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Leverage FCF (A \$, Millions) 32.6 million Australian dollars 102.1 million Australian dollars AUD 117.2 million 128.3 million Australian dollars A \$ 136.5 million AU \$ 143.4 million AUD 149.3 million 154.4 million Australian dollars A \$ 158.9 million AU \$ 163.1 million Source of estimated growth rate Analyst x2 Analyst x2 Analyst x2 Analyst x2 East @ 6.4% East @ 5.04% East @ 4.08% East @ 3.42% Est @ 2.95% East @ 2.62% Present value (A \$, Millions) discounted at 7.3% A \$ 30.4 A \$ 88.6 A \$ 94.9 A \$ 96.8 A \$ 96.0 A \$ 93.9 AU \$ 91.1 A \$ 87.8 AU \$ 84.3 80.6 AUD

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = AU \$ 844 million

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. 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 (1.9%) to estimate future growth. Similar to the 10-year â€œgrowthâ€ period, we discount future cash flows to their present value, using a cost of equity of 7.3%.

Terminal value (TV)= FCF2031 Ã— (1 + g) Ã· (r – g) = AU \$ 163 million Ã— (1 + 1.9%) Ã· (7.3% to 1.9%) = AU \$ 3.1 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= AU \$ 3.1 billion Ã· (1 + 7.3%)ten= AU \$ 1.5 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is AU \$ 2.4 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of AU \$ 15.4, the company appears to be quite undervalued with a 47% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

### Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. 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 consider Nick Scali 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 debt into account. In this calculation, we used 7.3%, which is based on a leveraged beta of 1.243. 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 an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

### Next steps:

While important, calculating DCF is just one of the many factors you need to assess for a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. What is the reason why the stock price is below intrinsic value? For Nick Scali, we’ve compiled three more things you should explore:

1. Risks: Concrete example, we have spotted 2 warning signs for Nick Scali you must be aware.
2. Future benefits: How does NCK’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number 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 may not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, 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 any stock 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.