Downer EDI Limited's (ASX:DOW) Intrinsic Value Is Potentially 82% Above Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Downer EDI fair value estimate is AU$8.88

• Downer EDI's AU$4.87 share price signals that it might be 45% undervalued

• Analyst price target for DOW is AU$4.88 which is 45% below our fair value estimate

How far off is Downer EDI Limited (ASX:DOW) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Downer EDI

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$331.0m	AU$397.7m	AU$414.4m	AU$461.8m	AU$402.2m	AU$369.2m	AU$350.5m	AU$340.5m	AU$336.0m	AU$335.1m
Growth Rate Estimate Source	Analyst x2	Analyst x3	Analyst x3	Analyst x3	Analyst x2	Est @ -8.20%	Est @ -5.06%	Est @ -2.86%	Est @ -1.33%	Est @ -0.25%
Present Value (A$, Millions) Discounted @ 7.3%	AU$308	AU$345	AU$335	AU$348	AU$282	AU$242	AU$214	AU$193	AU$178	AU$165

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$2.6b

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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$335m× (1 + 2.3%) ÷ (7.3%– 2.3%) = AU$6.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$6.8b÷ ( 1 + 7.3%)¹⁰= AU$3.3b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$6.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$4.9, the company appears quite good value at a 45% 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

Important Assumptions

We would point out that 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 Downer EDI 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 7.3%, which is based on a levered beta of 1.100. 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.

SWOT Analysis for Downer EDI

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

• Dividend is low compared to the top 25% of dividend payers in the Commercial Services market.

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Good value based on P/S ratio and estimated fair value.

Threat

• Paying a dividend but company is unprofitable.

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Downer EDI, we've put together three important items you should assess:

1. Risks: Case in point, we've spotted 1 warning sign for Downer EDI you should be aware of.

2. Future Earnings: How does DOW'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.