Are Investors Undervaluing Downer EDI Limited (ASX:DOW) By 40%?

Key Insights

• The projected fair value for Downer EDI is AU$7.22 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$4.30 suggests Downer EDI is potentially 40% undervalued

• Analyst price target for DOW is AU$4.36 which is 40% below our fair value estimate

How far off is Downer EDI Limited (ASX:DOW) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Downer EDI

What's The Estimated Valuation?

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$248.5m	AU$304.5m	AU$331.0m	AU$369.1m	AU$346.0m	AU$333.8m	AU$327.7m	AU$325.5m	AU$326.0m	AU$328.4m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Est @ -3.52%	Est @ -1.84%	Est @ -0.67%	Est @ 0.16%	Est @ 0.73%
Present Value (A$, Millions) Discounted @ 7.9%	AU$230	AU$261	AU$263	AU$272	AU$236	AU$211	AU$192	AU$177	AU$164	AU$153

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$2.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.1%) 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 7.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$328m× (1 + 2.1%) ÷ (7.9%– 2.1%) = AU$5.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$5.7b÷ ( 1 + 7.9%)¹⁰= AU$2.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$4.8b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$4.3, the company appears quite good value at a 40% 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. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 Downer EDI 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 7.9%, which is based on a levered beta of 1.168. 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 Downer EDI

Strength

• Net debt to equity ratio below 40%.

Weakness

• Interest payments on debt are not well covered.

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

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

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

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Downer EDI, we've put together three fundamental aspects you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Downer EDI , and understanding this should be part of your investment process.

2. Future Earnings: How does DOW'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock 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.