In this article, we will estimate the intrinsic value of Lennar Corporation (NYSE:LEN) by taking the company’s expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.

We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.

See our latest analysis for Lennar

Step by step in the calculation

We will use a two-stage 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 “sustained growth”. 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, and so the sum of these 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 discounted cash flow (PVCF) = $16 billion

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 the terminal cash flows to their present value at a cost of equity of 7.1%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = $1.2 billion × (1 + 1.9%) ÷ (7.1%–1.9%) = $23 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= $23 billion ÷ (1 + 7.1%)^ten= $12 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $27 billion. In the last step, we divide the equity value by the number of shares outstanding. Based on the current share price of $81.2, the company appears to be approximately fair value at a 12% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.

The hypotheses

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 view Lennar 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 factors in debt. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.215. 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.

Let’s move on :

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. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For Lennar, we’ve compiled three more things you should explore:

1. Risks: Take risks, for example – Lennar has 2 warning signs (and 1 which is significant) that we think you should know about.
2. Management:Did insiders increase their shares to take advantage of market sentiment about LEN’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
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 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 every stock on the NYSE 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.