Today we’re going to review a valuation method used to estimate the attractiveness of Orora Limited (ASX: ORA) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.

We draw your attention to the fact that there are many ways to assess 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 review for Orora

Step by step in the calculation

We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. 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.

In general, 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) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = AU $ 1.5 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 step. For a number of reasons, a very conservative growth rate is used that 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 (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.1%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = A $ 228 million × (1 + 1.9%) ÷ (6.1% to 1.9%) = A $ 5.6 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= 5.6 billion Australian dollars ÷ (1 + 6.1%)^ten= AU $ 3.1 billion

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is AU $ 4.6 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of AU $ 3.2, the company appears to be quite undervalued with a 39% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 Orora as a potential shareholder, 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 6.1%, which is based on a leveraged beta of 0.884. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price is below intrinsic value? For Orora, we’ve compiled three additional factors that you should take a closer look at:

1. Risks: Note that Orora shows 2 warning signs in our investment analysis , you must know…
2. Future benefits: How does ORA’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you might not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, just 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 using only unbiased methodology and our articles are not intended to be financial advice. 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 documents. Simply Wall St has no position in the mentioned stocks.
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