Today we are going to review a valuation method used to estimate the attractiveness of JB Hi-Fi Limited (ASX: JBH) as an investment opportunity by taking the forecast of future cash flows from the company and discounting them to today’s value. . This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!
Keep in mind, however, that there are many ways to estimate the value of a business, and a DCF is just one method. 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.
Check out our latest review for JB Hi-Fi
What is the estimated valuation?
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During 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.
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
|Leverage FCF (A $, Millions)||AU $ 338.0 million||AU $ 402.9 million||AU $ 415.2 million||AU $ 394.0 million||AU $ 345.0 million||AU $ 334.8 million||A $ 329.8 million||328.2 million Australian dollars||328.9 million Australian dollars||AU $ 331.2 million|
|Source of estimated growth rate||Analyst x7||Analyst x7||Analyst x7||Analyst x3||Analyst x1||East @ -2.94%||Estimate @ -1.5%||East @ -0.49%||East @ 0.21%||Is @ 0.71%|
|Present value (A $, Millions) discounted at 7.3%||AU $ 315||AU $ 350||AU $ 336||AU $ 297||242 AU $||AU $ 219||A $ 201||A $ 186||A $ 174||AU $ 163|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 2.5 billion Australian dollars
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. 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 1.9%. We discount the terminal cash flows to their present value at a cost of equity of 7.3%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = AU $ 331 million Ã (1 + 1.9%) Ã· (7.3% to 1.9%) = AU $ 6.2 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= AU $ 6.2b Ã· (1 + 7.3%)ten= AU $ 3.0 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is AU $ 5.5 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of AU $ 49.1, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. 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 full picture of a company’s potential performance. Since we view JB Hi-Fi 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 7.3%, which is based on a leveraged beta of 1.250. 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 of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
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 ultimate solution for 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. For JB Hi-Fi, we have put together three other factors that you need to assess:
- Risks: Concrete example, we have spotted 2 warning signs for JB Hi-Fi you should be aware of it, and one of them doesn’t suit us very well.
- Future benefits: How does JBH’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.
- 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 may not have considered!
PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.
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 any of the stocks mentioned.
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