Does the December share price for Aris Water Solutions, Inc. (NYSE:ARIS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
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. To begin with, we have to get estimates of the next ten years of cash flows. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$78.2m
US$92.1m
US$100.8m
US$112.6m
US$121.5m
US$129.2m
US$135.9m
US$141.9m
US$147.4m
US$152.6m
Growth Rate Estimate Source
Analyst x5
Analyst x2
Analyst x1
Analyst x1
Est @ 7.89%
Est @ 6.31%
Est @ 5.20%
Est @ 4.43%
Est @ 3.89%
Est @ 3.51%
Present Value ($, Millions) Discounted @ 7.0%
US$73.1
US$80.4
US$82.3
US$85.9
US$86.7
US$86.1
US$84.7
US$82.7
US$80.3
US$77.7
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$820m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$3.6b÷ ( 1 + 7.0%)10= US$1.8b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$2.6b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$26.9, the company appears quite good value at a 41% 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.
NYSE:ARIS Discounted Cash Flow December 1st 2024
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 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 Aris Water Solutions 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 7.0%, which is based on a levered beta of 1.060. 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 Aris Water Solutions
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by cash flow.
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
Annual earnings are forecast to grow faster than the American market.
Good value based on P/E ratio and estimated fair value.
Threat
Dividends are not covered by cash flow.
Annual revenue is forecast to grow slower than the American market.
Next Steps:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for 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 significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Aris Water Solutions, we've put together three important items you should further research:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ARIS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks 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.
