Does Otis Worldwide Corporation (NYSE: OTIS) share price in December reflect its true value? Today we’re going to estimate the intrinsic value of the stock by projecting its future cash flows and then discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. There really isn’t much to do, although it might seem quite complex.

We generally think of a business’s value as 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 passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

What is the estimated valuation?

We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. First, 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, and therefore the sum of those future cash flows is then discounted to today’s value. :

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 12 billion

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. For a number of reasons, a very conservative growth rate is used that 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 (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.9%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 2.0B × (1 + 2.0%) ÷ (6.9% – 2.0%) = US $ 40B

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 40 billion ÷ (1 + 6.9%)^ten= US $ 21 billion

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 $ 33 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 80.5, the company appears to be 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.

NYSE: OTIS Discounted Cash Flow December 2, 2021

Important assumptions

Now, the most important inputs to a discounted cash flow are 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 full picture of a company’s potential performance. Since we view Otis Worldwide as a potential shareholder, 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 6.9%, which is based on a leveraged beta of 1.131. 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.

To move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. DCF models are not the ultimate solution for investment valuation. 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, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Otis Worldwide, we’ve compiled three more things you should take a look at:

1. Risks: For example, we have identified 2 warning signs for Otis Worldwide (1 is concerning) you should be aware of.
2. Future benefits: How does OTIS’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.
3. 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. 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.

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