In this article, we’ll estimate the intrinsic value of CTS Corporation (NYSE: CTS) by taking expected future cash flows and discounting them to today’s value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

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. If you are interested in knowing more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

Crunch the numbers

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. To begin with, we need to estimate the next ten years of cash flow. 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.

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:

10-year Free Cash Flow (FCF) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leverage FCF ($, Millions) US $ 58.3 million US $ 60.1 million US $ 57.8 million US $ 56.5 million US $ 56.0 million US $ 56.0 million US $ 56.3 million US $ 56.8 million US $ 57.6 million 58.4 million US dollars
Source of estimated growth rate Analyst x1 Analyst x1 Is @ -3.9% Est @ -2.14% East @ -0.91% East @ -0.05% Is @ 0.55% Est @ 0.98% Est @ 1.27% Is @ 1.48%
Present value (in millions of dollars) discounted at 7.0% $ 54.4 US $ 52.5 US $ 47.1 US $ 43.1 US $ 39.9 US $ 37.2 US $ 35.0 US $ 33.0 US $ 31.2 $ 29.6

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 403 million US dollars

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. 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 their present value, using a cost of equity of 7.0%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 58 million × (1 + 2.0%) ÷ (7.0% – 2.0%) = US $ 1.2 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 1.2 billion ÷ (1 + 7.0%)ten= US $ 595 million

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 998 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US $ 34.2, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

NYSE: CTS Discounted Cash Flow December 18, 2021

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. 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 CTS 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 7.0%, which is based on a leveraged beta of 1.158. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. The DCF model is not a perfect stock assessment tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” 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 CTS, we have gathered three relevant aspects to consider:

  1. Financial health: Does CTS have a healthy track record? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future benefits: How does CTS’s growth rate compare to 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 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 US 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 documents. Simply Wall St has no position in any of the stocks mentioned.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.