Is there an opportunity with the 41% undervaluation of Vector Limited (NZSE:VCT)?
In this article, we will estimate the intrinsic value of Vector Limited (NZSE:VCT) by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
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. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check out our latest analysis for Vector
Step by step in 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. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest 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:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (NZ$, Millions)||NZ$61.2 million||NZ$93.3 million||NZ$128.0 million||NZ$162.1 million||NZ$193.3 million||NZ$220.6 million||NZ$243.7 million||NZ$263.1 million||NZ$279.3 million||NZ$293.1 million|
|Growth rate estimate Source||Is at 73.81%||Is at 52.28%||East @ 37.21%||Is at 26.66%||Is at 19.27%||Is at 14.1%||Is at 10.48%||Is 7.95%||Is at 6.18%||Is at 4.94%|
|Present value (in millions of New Zealand dollars) discounted at 5.4%||$58.1||$83.9||$109||$131||$148||$161||$168||$172||$174||$173|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = NZ$1.4 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. 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 (2.0%) 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 5.4%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = NZ$293 million × (1 + 2.0%) ÷ (5.4%–2.0%) = NZ$8.8 billion zeelandic
Present value of terminal value (PVTV)= TV / (1 + r)ten= NZ$8.8 billion ÷ (1 + 5.4%)ten= NZ$5.2 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is NZ$6.6 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 NZ$3.9, the company looks quite undervalued at a 41% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
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 Vector 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 5.4%, which is based on a leveraged beta of 0.800. 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.
While important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible 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 the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is the stock price below intrinsic value? For Vector, we’ve compiled three essentials you should dig into:
- Risks: For example, we have identified 3 vector warning signs (2 are potentially serious) of which you should be aware.
- Future earnings: How does VCT’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 each stock on the NZSE every day. If you want to find the calculation for other stocks, 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.