Are investors undervaluing Fletcher Building Limited (NZSE:FBU) by 44%?
Today we’ll walk through one way to estimate the intrinsic value of Fletcher Building Limited (NZSE:FBU) by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
Check out our latest analysis for Fletcher Building
Calculate numbers
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF (NZ$, Millions) | NZ$277.9 million | NZ$606.9 million | NZ$548.3 million | NZ$549.7 million | NZ$588.2 million | NZ$587.9 million | NZ$591.4 million | NZ$597.6 million | NZ$605.7 million | NZ$615.2 million |
Growth rate estimate Source | Analyst x6 | Analyst x6 | Analyst x5 | Analyst x2 | Analyst x2 | East @ -0.04% | Is at 0.6% | Is at 1.04% | Is at 1.36% | Is at 1.58% |
Present value (in millions of New Zealand dollars) discounted at 9.2% | $255 | $509 | $421 | $387 | $379 | $347 | $320 | $296 | $275 | $256 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = NZ$3.4 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which 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 (2.1%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 9.2%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = NZ$615 million × (1 + 2.1%) ÷ (9.2%–2.1%) = NZ$8.9 billion zeelandic
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= NZ$8.9 billion ÷ (1 + 9.2%)^{ten}= NZ$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 equity value, which in this case is NZ$7.1 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of NZ$5.2, the company appears to have pretty good value at a 44% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The hypotheses
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the 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 consider Fletcher Building 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 9.2%, which is based on a leveraged beta of 1.382. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
SWOT analysis for the Fletcher building
- Earnings growth over the past year has exceeded that of the industry.
- Debt is not considered a risk.
- The dividend is among the top 25% dividend payers in the market.
- Earnings growth over the past year is below its 5-year average.
- Annual revenues are expected to increase over the next 3 years.
- Good value based on P/E ratio and estimated fair value.
- Dividends are not covered by cash flow.
- Annual earnings are expected to grow more slowly than the New Zealand market.
Look forward:
Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is the stock price below intrinsic value? For Fletcher Building, we’ve put together three relevant factors you should consider:
- Risks: For example, we discovered 1 warning sign for the Fletcher building which you should be aware of before investing here.
- Future earnings: How does FBU’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- 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 strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NZSE every day. If you want to find the calculation for other stocks, search here.
Valuation is complex, but we help make it simple.
Find out if Fletcher Building is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
See the free analysis
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.