Today we’re going to go over one way to estimate the intrinsic value of Norsk Hydro ASA (OB: NHY) by projecting its future cash flows and then discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
Remember, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Check out our latest review for Norsk Hydro
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”. First, 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.
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
|Leverage FCF (NOK, Millions)||kr13.0b||kr12.4b||kr10.9b||kr10.2b||kr9.76b||kr9.52b||kr9.39b||kr9.33b||kr9.32b||9.35 kr|
|Source of estimated growth rate||Analyst x5||Analyst x3||Analyst x1||Analyst x1||Is @ -4.04%||East @ -2.48%||Is @ -1.39%||East @ -0.63%||Estimate @ -0.1%||Is @ 0.28%|
|Present value (NOK, millions) discounted at 6.3%||12.2k kr||11.0k kr||kr9.1k||8.0 kr||7.2k kr||6.6 kr||kr6.1k||5.7k kr||5.4 kr||kr5.1k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = kr76b
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 (1.2%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.3%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = kr9.3b × (1 + 1.2%) ÷ (6.3% – 1.2%) = kr185b
Present value of terminal value (PVTV)= TV / (1 + r)ten= kr185b ÷ (1 + 6.3%)ten= kr101b
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 kr177b. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current stock price of 68.3 kr, the company appears to be slightly undervalued at a 21% discount from where the stock price is currently trading. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
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. 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 view Norsk Hydro as a potential shareholder, 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 6.3%, which is based on a leveraged beta of 1.168. 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.
While a business valuation is important, ideally it won’t be the only analysis that you look at for a business. The DCF model is not a perfect equity 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, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Why is intrinsic value greater than the current share price? For Norsk Hydro, we’ve put together three important things you should research further:
- Risks: To do this, you need to know the 2 warning signs we spotted with Norsk Hydro.
- Future benefits: How does NHY’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.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every Norwegian stock every day, so if you want to find the intrinsic value of any other stock just 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 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 material. Simply Wall St has no position in any of the stocks mentioned.