NYSE:SO) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. There’s really not all that much to it, even though it might appear quite complex.” data-reactid=”28″ type=”text”>In this article we are going to estimate the intrinsic value of The Southern Company (NYSE:SO) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. There’s really not all that much to it, even though it might appear quite complex.
Simply Wall St analysis model.” data-reactid=”29″ type=”text”>We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Step by step through the calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. To begin with, we have to get estimates of the next ten years of cash flows. 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
|Levered FCF ($, Millions)||-US$179.0m||US$659.5m||US$1.10b||US$1.63b||US$2.19b||US$2.73b||US$3.22b||US$3.64b||US$4.00b||US$4.31b|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 67.46%||Est @ 47.88%||Est @ 34.19%||Est @ 24.6%||Est @ 17.88%||Est @ 13.18%||Est @ 9.89%||Est @ 7.59%|
|Present Value ($, Millions) Discounted @ 7.0%||-US$167.2||US$576||US$901||US$1.2k||US$1.6k||US$1.8k||US$2.0k||US$2.1k||US$2.2k||US$2.2k|
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. 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 2.2%. We discount the terminal cash flows to today’s value at a cost of equity of 7.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$92b÷ ( 1 + 7.0%)10= US$46b” data-reactid=”44″ type=”text”>Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$92b÷ ( 1 + 7.0%)10= US$46b
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$61b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$53.2, the company appears about fair value at a 7.6% 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.
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 Southern 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 7.0%, which is based on a levered beta of 0.800. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Southern, we’ve compiled three pertinent elements you should look at:
- Risks: Be aware that Southern is showing 1 warning sign in our investment analysis , you should know about…
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for SO’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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!
search here.” data-reactid=”70″ type=”text”>PS. Simply Wall St updates its DCF calculation for every American 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. 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.