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Is Ferrexpo plc (LON:FXPO) Trading At A 34% Discount?

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Ferrexpo plc (LON:FXPO) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. We will tak…

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Ferrexpo plc (LON:FXPO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you. View our latest analysis for Ferrexpo

Step by step through the calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth.

In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value.

We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years. Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (£, Millions)

US£746.3m

US£387.3m

US£401.0m

US£308.0m

US£258.8m

US£230.6m

US£213.7m

US£203.3m

US£196.9m

US£193.1m

Growth Rate Estimate Source

Analyst x4

Analyst x3

Analyst x1

Est @ -23.19%

Est @ -15.96%

Est @ -10.9%

Est @ -7.35%

Est @ -4.87%

Est @ -3.13%

Est @ -1.92%

Present Value (£, Millions) Discounted @ 5.9%

US£705

US£346

US£338

US£245

US£195

US£164

US£143

US£129

US£118

US£109

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US£2.5b

Story continues We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.9%.

We discount the terminal cash flows to today's value at a cost of equity of 5.9%. Terminal Value (TV)= FCF2031 x (1 + g) / (r - g) = US£193mx (1 + 0.9%) / (5.9%- 0.9%) = US£3.9b Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US£3.9b/ ( 1 + 5.9%)10= US£2.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US£4.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UKGBP3.8, the company appears quite good value at a 34% discount to where the stock price trades currently.

The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

dcf

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance.

Given that we are looking at Ferrexpo 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 accounts for debt. In this calculation we've used 5.9%, which is based on a levered beta of 1.047. Beta is a measure of a stock's volatility, compared to the market as a whole.

We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued.

For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Ferrexpo, we've put together three relevant elements you should further examine:

  1. Risks: For example, we've discovered 3 warning signs for Ferrexpo (1 can't be ignored!) that you should be aware of before investing here.

  2. Future Earnings: How does FXPO's growth rate compare to its peers and the wider market?

    Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

Simply Wall St has no position in any stocks mentioned.

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