Yahoo Finance Fortescue Metals Group Limited (ASX:FMG) Is Trading At A 37.58% Discount
Does the share price for Fortescue Metals Group Limited (ASX:FMG) reflect it’s really worth? Today, I will calculate the stock’s intrinsic value by estimating the company’s future cash flows and discounting them to their present value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not June 2018 then I highly recommend you check out the latest calculation for Fortescue Metals Group by following the link below. Check out our latest analysis for Fortescue Metals Group
What’s the value?
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. 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 forecast
2018 | 2019 | 2020 | 2021 | 2022 | |
Levered FCF ($, Millions) | $857.46 | $1.21k | $1.77k | $1.33k | $1.78k |
Source | Analyst x7 | Analyst x9 | Analyst x3 | Analyst x2 | Analyst x1 |
Present Value Discounted @ 11.67% | $767.85 | $968.33 | $1.27k | $853.48 | $1.03k |
Present Value of 5-year Cash Flow (PVCF)= AU$4.89b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today’s value at a cost of equity of 11.7%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = AU$1.78b × (1 + 2.8%) ÷ (11.7% – 2.8%) = AU$20.56b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$20.56b ÷ ( 1 + 11.7%)5 = AU$11.84b
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 AU$16.73b. 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 in the company’s reported currency of $5.38. However, FMG’s primary listing is in Australia, and 1 share of FMG in USD represents 1.356 ( USD/ AUD) share of OTCPK:FSUM.F, so the intrinsic value per share in AUD is A$7.29. Compared to the current share price of A$4.55, the stock is quite good value at a 37.58% discount to what it is available for right now.
Important assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Fortescue Metals Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 11.7%, which is based on a levered beta of 1.231. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For FMG, there are three pertinent aspects you should further research:
Financial Health: Does FMG have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Future Earnings: How does FMG’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.
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of FMG? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the ASX every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
