How far is Tetra Tech, Inc. (NASDAQ: TTEK) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check out our latest analysis for Tetra Tech
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”. In the first step, we need to estimate the company’s cash flow over 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, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$296.7 million||$263.9 million||$276.9 million||$268.1 million||$263.7 million||$262.2 million||$262.7 million||$264.5 million||$267.4 million||$270.9 million|
|Growth rate estimate Source||Analyst x4||Analyst x5||Analyst x2||East @ -3.16%||Is @ -1.63%||Is @ -0.57%||Is at 0.18%||Is at 0.7%||Is at 1.07%||Is at 1.32%|
|Present value (in millions of dollars) discounted at 5.9%||$280||$235||$233||$213||$198||$186||$176||$167||$160||$153|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = US$2.0 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 stage. 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 terminal cash flows to present value at a cost of equity of 5.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = $271 million × (1 + 1.9%) ÷ (5.9%–1.9%) = $7.0 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $7.0 billion ÷ (1 + 5.9%)ten= $3.9 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $5.9 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US$130, the company appears 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 a different galaxy. Keep that in mind.
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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Tetra Tech 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 5.9%, which is based on a leveraged beta of 0.935. 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. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. For Tetra Tech, there are three important aspects that you should examine in more detail:
- Risks: For example, we discovered 2 warning signs for Tetra Tech which you should be aware of before investing here.
- Management:Did insiders increase their shares to take advantage of market sentiment about TTEK’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a 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.