An intrinsic calculation for Vertiv Holdings Co (NYSE:VRT) suggests it is 38% undervalued
Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of Vertiv Holdings Co (NYSE:VRT) as an investment opportunity by taking future cash flows expected and discounting them to the present value. One way to do this is to use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
Check out our latest analysis for Vertiv Holdings Co
The method
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
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF ($, millions) | $376.6 million | $485.9 million | $651.0 million | $636.0 million | $630.1 million | $629.8 million | $633.1 million | $639.2 million | $647.2 million | $656.7 million |
Growth rate estimate Source | Analyst x5 | Analyst x5 | Analyst x2 | Analyst x1 | Is @ -0.92% | East @ -0.06% | Is at 0.54% | Is 0.96% | Is at 1.25% | Is at 1.46% |
Present value (in millions of dollars) discounted at 8.7% | $346 | $411 | $507 | $456 | $415 | $382 | $353 | $328 | $305 | $285 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $3.8 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 8.7%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = US$657 million × (1 + 1.9%) ÷ (8.7%–1.9%) = US$9.9 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $9.9 billion ÷ (1 + 8.7%)^{ten}= $4.3 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $8.1 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 US$13.4, the company appears to be pretty good value at a 38% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The hypotheses
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Vertiv Holdings Co 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 factors in debt. In this calculation, we used 8.7%, which is based on a leveraged beta of 1.595. 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.
Next steps:
While important, calculating DCF shouldn’t be the only metric to consider when researching a business. The DCF model is not a perfect stock valuation tool. 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 Vertiv Holdings Co, there are three relevant items you should dig into:
- Risks: Be aware that Vertiv Holdings Co displays 3 warning signs in our investment analysis and 1 of them is a little unpleasant…
- Future earnings: How does VRT’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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