Today we are going to take a simple overview of a valuation method used to estimate the attractiveness of Iridium Communications Inc. (NASDAQ: IRDM) as an investment opportunity by taking the flows of expected future cash flows and discounting them to their present 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 easy enough to follow.

We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should have a read of the Simply Wall St.

The calculation

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 the last published value. 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 down during this period. We do this to reflect 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, and so the sum of these future cash flows is then discounted to present value:

10-year free cash flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = $ 2.0 billion

Now we need to calculate the terminal value, which takes into account all future cash flows after that 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 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.2%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = $ 275 million × (1 + 2.0%) ÷ (6.2% – 2.0%) = $ 6.7 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= $ 6.7 billion ÷ (1 + 6.2%)^ten= $ 3.7 billion

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 $ 5.6 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 37.7, the company appears to have fair value at a 10% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

NasdaqGS: IRDM Discounted Cash Flow April 22, 2021

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is making 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 complete picture of a company’s potential performance. Since we view Iridium Communications 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 6.2%, which is based on a leverage beta of 0.800. 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.

Looking forward:

While important, the DCF calculation is just one of the many factors you need to assess for a business. It is not possible to obtain an infallible valuation with a DCF model. 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. For Iridium Communications, there are three essentials that you should explore:

1. Risks: Concrete example, we have spotted 3 warning signs for Iridium Communications you must be aware of this, and one of them must not be ignored.
2. Management: Have insiders increased their shares to take advantage of market sentiment for IRDM’s future outlook? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other strong companies: Low debt, high returns on equity, and good past performance are essential 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. 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.

This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.

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