How far is The Gorman-Rupp Company (NYSE:GRC) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking the expected future cash flows and discounting them to the present value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are actually quite simple.
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check opportunities and risks within the American machinery industry.
We use what is called a 2-step 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. 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)||$47.7 million||$48.1 million||$48.7 million||$49.4 million||$50.1 million||$51.0 million||$51.9 million||$52.9 million||$53.9 million||$54.9 million|
|Growth rate estimate Source||Analyst x1||Is at 0.81%||Is at 1.16%||Is at 1.41%||Is at 1.58%||Is at 1.7%||Is at 1.78%||Is at 1.84%||Is at 1.88%||Is at 1.91%|
|Present value (in millions of dollars) discounted at 8.1%||$44.2||$41.2||$38.5||$36.2||$34.0||$32.0||$30.1||$28.4||$26.7||$25.2|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $336 million
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. 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 (2.0%) 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 8.1%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $55 million × (1 + 2.0%) ÷ (8.1%–2.0%) = $917 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= $917m ÷ (1 + 8.1%)ten= $421 million
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 $757 million. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of $23.7, the company appears to be about fair value at an 18% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. 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 view Gorman-Rupp 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 factors in debt. In this calculation, we used 8.1%, which is based on a leveraged beta of 1.304. 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.
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. The DCF model is not a perfect stock valuation tool. 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 Gorman-Rupp, we’ve compiled three essentials you should evaluate:
- Risks: For example, we have identified 5 warning signs for Gorman-Rupp (2 are concerning) that you should be aware of.
- Future earnings: How does GRC’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- 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 NYSE 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.
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