Today, we’ll walk through one way to estimate the intrinsic value of The Western Union Company (NYSE:WU) by taking the company’s expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$901.0 million||$849.7 million||$798.0 million||$794.0 million||$796.0 million||$802.0 million||$810.8 million||$821.8 million||$834.3 million||$847.9 million|
|Growth rate estimate Source||Analyst x5||Analyst x3||Analyst x1||Analyst x1||Is 0.25%||Is at 0.75%||Is at 1.1%||Is at 1.35%||Is at 1.52%||Is at 1.64%|
|Present value (millions of dollars) discounted at 7.1%||$841||$740||$649||$603||$564||$530||$501||$474||$449||$426|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $5.8 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which 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 (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$848 million × (1 + 1.9%) ÷ (7.1%–1.9%) = US$17 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $17 billion ÷ (1 + 7.1%)ten= $8.3 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $14 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 $18.4, the company appears to be good value at a 48% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. 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 complete picture of a company’s potential performance. Since we consider Western Union 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 debt into account. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.229. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of 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 have a significant impact on the valuation. Can we understand why the company is trading at a discount to its intrinsic value? For Western Union, we have put together three relevant factors that you should consider in more detail:
- Risks: For example, we spotted 1 warning sign for Western Union you should be aware.
- Future earnings: How does WU’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, search here.
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