How far is Century Aluminum Company (NASDAQ: CENX) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock’s price is fair by projecting its future cash flows and then discounting them to present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!

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. For those who are learning equity analysis in depth, the Simply Wall St analysis template here may be of interest to you.

The method

We use what is called a 2-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 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 during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.

Typically, 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) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 900 million USD

The second stage is also known as terminal value, it 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 7.6%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = $ 42 million × (1 + 2.0%) ÷ (7.6% – 2.0%) = $ 766 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= 766 million USD ÷ (1 + 7.6%)^ten= 367 million USD

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 1.3 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 15.1, the company is around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

NasdaqGS: CENX Discounted Cash Flow May 17, 2021

The hypotheses

Now the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play 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 view Century Aluminum 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 7.6%, which is based on a leveraged beta of 1.196. 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.

Next steps:

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. The DCF model is not a perfect inventory valuation tool. Preferably, you would apply different cases and assumptions and see how they would impact 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. For Century Aluminum, we’ve compiled three foundational elements that you should explore:

1. Risks: Concrete example, we have spotted 3 warning signs for Century Aluminum you have to be aware of it.
2. Future income: How does CENX’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
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. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, 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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