Does the September share price for Transurban Group (ASX: TCL) reflect what it is really worth? Today we’re going to estimate the intrinsic value of the stock by taking the company’s future cash flow forecast and discounting it to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

See our latest analysis for Transurban Group

The model

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 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) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = AU $ 15 billion

It is now a matter of calculating 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 (1.9%) 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 8.2%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU $ 3.4 billion × (1 + 1.9%) ÷ (8.2% to 1.9%) = AU $ 55 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= AU $ 55 billion ÷ (1 + 8.2%)^ten= 25 billion Australian dollars

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is AU $ 40 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of AU $ 14.5, the company appears to be roughly at fair value with a 1.6% discount to the current share price. 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.

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with 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 full picture of a company’s potential performance. Since we view Transurban 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 8.2%, which is based on a leveraged beta of 1.341. 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 :

While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. It is not possible to achieve a rock-solid 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, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Transurban Group, there are three fundamental things you should be looking at:

1. Risks: Consider, for example, the ever-present specter of investment risk. We have identified 2 warning signs with Transurban Group, and understanding them should be part of your investment process.
2. Future benefits: How does TCL’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count 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 might not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, 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 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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