Is DR Horton, Inc. (NYSE:DHI) expensive for a reason? A look at its intrinsic value
In this article, we will estimate the intrinsic value of DR Horton, Inc. (NYSE: DHI) by estimating the company’s future cash flows and discounting them to their present value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are actually quite simple.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
See our latest analysis for DR Horton
The calculation
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 begin with, we need to obtain cash flow estimates 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.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF ($, millions) | $3.27 billion | $3.32 billion | $1.99 billion | $1.36 billion | $1.06 billion | $907.7 million | $820.4 million | $769.8 million | $741.1 million | $726.0 million |
Growth rate estimate Source | Analyst x3 | Analyst x3 | Analyst x1 | Is @ -31.73% | Is @ -21.64% | Is @ -14.57% | Is @ -9.62% | Is @ -6.16% | Is @ -3.74% | East @ -2.04% |
Present value (millions of dollars) discounted at 7.0% | $3,100 | $2,900 | $1,600 | $1,000 | $757 | $605 | $511 | $448 | $403 | $369 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $12 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond 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 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 7.0%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = $726 million × (1 + 1.9%) ÷ (7.0%–1.9%) = $15 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $15 billion ÷ (1 + 7.0%)^{ten}= $7.4 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $19 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of US$66.5, the company appears slightly overvalued at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
Important assumptions
We emphasize that 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 DR Horton to be 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 7.0%, which is based on a leveraged beta of 1.199. 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.
Next steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or in the risk-free rate can have a significant impact on the valuation. What is the reason why the stock price exceeds the intrinsic value? For DR Horton, we have compiled three additional aspects that you should explore:
- Risks: For example, we discovered 4 warning signs for DR Horton (2 doesn’t sit too well with us!) which you should be aware of before investing here.
- Management:Did insiders increase their shares to take advantage of market sentiment about DHI’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a 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 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.