The intrinsic value of Northern Star Resources Limited (ASX:NST) is potentially 59% higher than its share price
How far is Northern Star Resources Limited (ASX:NST) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by projecting its future cash flows and then discounting them to the present value. Our analysis will use 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 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 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.
Check out our latest analysis for Northern Star Resources
The model
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF (A$, Millions) | A$642.3 million | A$905.5 million | A$1.18 billion | AU$1.29 billion | AU$1.06 billion | A$933.4 million | A$859.9 million | A$817.1 million | A$793.0 million | A$781.0 million |
Growth rate estimate Source | Analyst x3 | Analyst x4 | Analyst x4 | Analyst x2 | Analyst x1 | East @ -12.03% | East @ -7.88% | Is @ -4.98% | Is @ -2.94% | Is @ -1.52% |
Present value (A$, millions) discounted at 6.5% | AU$603 | AU$798 | AU$978 | AU$1,000 | $775 | $640 | AU$553 | AU$494 | $450 | AU$416 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = AU$6.7 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 (1.8%) 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 6.5%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = AU$781 million × (1 + 1.8%) ÷ (6.5%–1.8%) = AU$17 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= AU$17 billion÷ ( 1 + 6.5%)^{ten}= AU$9.0 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is A$16 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$8.5, the company looks quite undervalued at a 37% discount to the current share price. 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. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around 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 consider Northern Star Resources 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 6.5%, which is based on a leveraged beta of 1.108. 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 crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value higher than the current stock price? For Northern Star Resources, there are three fundamental factors you need to consider:
- Risks: Take risks, for example – Northern Star Resources has 4 warning signs (and 2 that we don’t like too much) that we think you should know about.
- Management:Did insiders increase their shares to take advantage of market sentiment regarding NST’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the ASX 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.