Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Alumina Limited (ASX:AWC) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for Alumina by following the link below.
Check out our latest analysis for Alumina
What’s the value?
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
| 2019 | 2020 | 2021 | 2022 | 2023 | |
| Levered FCF ($, Millions) | $526.74 | $432.15 | $354.00 | $359.00 | $416.44 |
| Source | Analyst x5 | Analyst x4 | Analyst x1 | Analyst x1 | Est @ 16%, capped from 42.03% |
| Present Value Discounted @ 9.75% | $479.94 | $358.76 | $267.77 | $247.42 | $261.51 |
Present Value of 5-year Cash Flow (PVCF)= US$1.6b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.8%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 9.8%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = US$416m × (1 + 2.8%) ÷ (9.8% – 2.8%) = US$6.1b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$6.1b ÷ ( 1 + 9.8%)5 = US$3.9b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$5.5b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of A$2.7. Compared to the current share price of A$2.3, the stock is about right, perhaps slightly undervalued at a 15% discount to what it is available for right now.