Today we are going to review a valuation method used to estimate the attractiveness of Alamo Group Inc. (NYSE: ALG) as an investment opportunity by taking expected future cash flows and breaking them down. discounting to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
Check out our latest analysis for the Alamo Group
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. First, we need to estimate the cash flow of the business over 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, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year free cash flow (FCF) forecast
|Leverage FCF ($, Millions)||US $ 85.2 million||US $ 106.2 million||$ 121.9 million||US $ 135.2 million||146.3 million US dollars||US $ 155.6 million||US $ 163.5 million||US $ 170.2 million||176.1 million US dollars||US $ 181.4 million|
|Source of estimated growth rate||Analyst x2||Analyst x1||Est @ 14.77%||Est @ 10.92%||East @ 8.23%||Est @ 6.35%||East @ 5.03%||Est @ 4.11%||East @ 3.47%||East @ 3.01%|
|Present value (in millions of dollars) discounted at 6.9%||$ 79.6||US $ 92.9||$ 99.7||103 USD||105 USD||104 USD||102 USD||$ 99.7||US $ 96.5||US $ 93.0|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 976 million
The second stage is also known as 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 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 (2.0%) 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 6.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 181 million × (1 + 2.0%) ÷ (6.9% – 2.0%) = US $ 3.7 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 3.7 billion ÷ (1 + 6.9%)ten= US $ 1.9 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 $ 2.9 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 $ 141, the company looks fairly good value at a 42% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is 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. Because we view Alamo Group 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 into account debt. In this calculation, we used 6.9%, which is based on a leveraged beta of 1.130. 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.
Move on :
While a business valuation is important, ideally it won’t be the only analysis that you 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. Why is intrinsic value greater than the current share price? For Alamo Group, we’ve compiled three fundamental factors you should explore:
- Risks: As an example, we have found 1 warning sign for the Alamo group that you need to consider before investing here.
- Future benefits: How does ALG’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 high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock 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 any stock 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.