How far is Alfa Laval AB (publ) (STO: ALFA) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking the company’s future cash flow forecast and discounting it to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
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 still have burning questions about this type of valuation, take a look at the Simply Wall St.
See our latest analysis for Alfa Laval
What is the estimated valuation?
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 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.
In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (SEK, millions)||kr4.42b||kr5.33b||6.65 kr||6.14 kr||5.83 kr||5.63 b||5.50 kr||5.41 kr||5.36 kr||kr5.33b|
|Source of estimated growth rate||Analyst x7||Analyst x6||Analyst x2||Analyst x1||Is @ -5.06%||Is @ -3.44%||East @ -2.31%||Is @ -1.52%||East @ -0.96%||East @ -0.58%|
|Present value (SEK, million) discounted at 5.0%||4.2k kr||4.8k kr||5.7k kr||5.0 kr||kr4.6k||4.2k kr||3.9k kr||kr3.7k||kr3.4k||kr3.3k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = kr43b
We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. 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 0.3%. We discount the terminal cash flows to their present value at a cost of equity of 5.0%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = kr5.3b × (1 + 0.3%) ÷ (5.0% – 0.3%) = kr114b
Present value of terminal value (PVTV)= TV / (1 + r)ten= kr114b ÷ (1 + 5.0%)ten= kr70b
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 kr113b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of 360kr, the company looks reasonably expensive at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
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 Alfa Laval 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 have used 5.0%, 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 of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Move on :
Valuation is only one side of the coin in terms of building your investment thesis, and ideally, it won’t be the only piece of analysis you look at for a business. The DCF model is not a perfect equity valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. What is the reason why the stock price exceeds intrinsic value? For Alfa Laval, there are three additional items that you should consider further:
- Risks: To do this, you need to know the 1 warning sign we spotted with Alfa Laval.
- Future benefits: How does ALFA’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 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 OM share. If you want to find the calculation for other actions, just search here.
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.
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.