Alamo Group Inc. (NYSE: ALG) shares may be 30% higher than their estimate of intrinsic value
Today we’re going to review one way to estimate the intrinsic value of Alamo Group Inc. (NYSE: ALG) by taking the company’s future cash flow forecasts and discounting them to the value of today. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.
There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you would like to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
See our latest analysis for the Alamo Group
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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. In the first step, 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, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 38.0 million||US $ 100.1 million||US $ 93.1 million||US $ 89.1 million||US $ 86.9 million||US $ 85.9 million||US $ 85.8 million||US $ 86.2 million||US $ 87.0 million||US $ 88.1 million|
|Source of estimated growth rate||Analyst x1||Analyst x1||Is @ -7.02%||Is @ -4.31%||East @ -2.42%||Is @ -1.1%||East @ -0.17%||Is @ 0.48%||Is 0.93%||Is @ 1.25%|
|Present value (in millions of dollars) discounted at 7.5%||US $ 35.4||US $ 86.7||US $ 75.0||US $ 66.8||$ 60.7||US $ 55.8||US $ 51.9||US $ 48.5||US $ 45.6||US $ 42.9|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 569 million
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. 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 7.5%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US $ 88 million × (1 + 2.0%) ÷ (7.5% to 2.0%) = US $ 1.6 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 1.6 billion ÷ (1 + 7.5%)ten= 802 million US dollars
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 $ 1.4 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 149, the company appears slightly overvalued 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. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play 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 Alamo Group 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 7.5%, which is based on a leveraged beta of 1.157. 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 a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
To move on :
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. It is not possible to achieve a rock-solid valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. 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. What is the reason why the stock price exceeds intrinsic value? For the Alamo Group, there are three additional things you need to assess:
- Risks: We think you should evaluate the 2 warning signs for the Alamo group we reported before making an investment in the business.
- Management: Have insiders increased their stocks to take advantage of market sentiment about ALG’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- 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. 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. It does not constitute a recommendation to buy or sell shares 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.
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