How far is Fabrinet (NYSE: FN) from his intrinsic worth? Using the most recent financial data, we’ll examine whether the stock price is fair by taking the company’s future cash flow forecast and discounting it to today’s value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to it, although it might seem quite complex.

We draw your attention to the fact that there are many ways to evaluate a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

See our latest analysis for Fabrinet

What is the estimated valuation?

We’re going to use a two-stage DCF model, which, as the name suggests, takes into account two growth stages. 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, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:

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 $ 1.6 billion

We now need to calculate the Terminal Value, which takes into account 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 of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 7.5%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = US $ 318 million × (1 + 2.0%) ÷ (7.5% to 2.0%) = US $ 5.9 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 5.9b (1 + 7.5%)^ten= US $ 2.9 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 4.5 billion. In the last step, we divide the equity value by the number of shares outstanding. From the current price of US $ 91.2, the company appears to be slightly undervalued at a 25% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 Fabrinet 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 7.5%, which is based on a leveraged beta of 1.160. 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 an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next steps:

While a business valuation is important, ideally it won’t be the only piece of analysis you will look at for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Can we understand why the company trades at a discount to its intrinsic value? For Fabrinet, we have gathered three relevant elements that you should explore:

1. Financial health: Does the FN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future benefits: How does FN’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 high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what else you might be missing!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. If you want to find the calculation for other actions, do a search here.

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This Simply Wall St article is general in nature. 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 material. Simply Wall St has no position in the mentioned stocks.
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