Is There An Opportunity With Duratec Limited's (ASX:DUR) 36% Undervaluation?

Key Insights

• The projected fair value for Duratec is AU$1.79 based on 2 Stage Free Cash Flow to Equity

• Duratec's AU$1.15 share price signals that it might be 36% undervalued

• Our fair value estimate is 25% higher than Duratec's analyst price target of AU$1.43

How far off is Duratec Limited (ASX:DUR) 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 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!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Duratec

The Method

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 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$4.60m	AU$30.7m	AU$28.2m	AU$26.9m	AU$26.2m	AU$25.9m	AU$25.8m	AU$26.0m	AU$26.3m	AU$26.7m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ -4.69%	Est @ -2.60%	Est @ -1.14%	Est @ -0.12%	Est @ 0.59%	Est @ 1.09%	Est @ 1.44%
Present Value (A$, Millions) Discounted @ 7.2%	AU$4.3	AU$26.7	AU$22.9	AU$20.4	AU$18.5	AU$17.1	AU$15.9	AU$14.9	AU$14.1	AU$13.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$168m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$27m× (1 + 2.3%) ÷ (7.2%– 2.3%) = AU$553m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$553m÷ ( 1 + 7.2%)¹⁰= AU$276m

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$444m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$1.1, the company appears quite good value at a 36% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Duratec 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 7.2%, which is based on a levered beta of 1.072. 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 Duratec

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

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

Opportunity

• Annual revenue is forecast to grow faster than the Australian market.

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

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to grow slower than the Australian market.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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. What is the reason for the share price sitting below the intrinsic value? For Duratec, there are three further items you should assess:

1. Risks: As an example, we've found 1 warning sign for Duratec that you need to consider before investing here.

2. Future Earnings: How does DUR'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.

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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.