Today I will be providing a simple run-through of the discounted cash flows (DCF) method to estimate the attractiveness of Downer EDI Limited (ASX:DOW) as an investment opportunity. If you want to learn more about this method, the basis for my calculations can be found in detail in the Simply Wall St analysis model. Also note that this article was written in March 2018 so be sure check the latest calculation for Downer EDI here.

What’s the value?

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, I pulled together the analyst consensus estimates of DOW’s levered free cash flow (FCF) over the next five years and discounted these values at the rate of 8.55%. When estimates weren’t available, I’ve extrapolated the average annual growth rate over the previous five years, capped at a reasonable level. This resulted in a present value of 5-year cash flow of AU$997.50M. Keen to understand how I calculated this value? Take a look at our detailed analysis here.

The graph above shows how DOW’s earnings are expected to move going forward, which should give you an idea of DOW’s outlook. Next, I determine the terminal value, which is the business’s cash flow after the first stage. I think it’s suitable to use the 10-year government bond rate of 2.8% as the steady growth rate, which is rightly below GDP growth, but more towards the conservative side. The present value of the terminal value after discounting it back five years is AU$3.45B.

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$4.45B. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value of A$7.53, which, compared to the current share price of A$6.61, we see that Downer EDI is about right, perhaps slightly undervalued at a 12.24% discount to what it is available for right now.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company.

For DOW, I’ve compiled three fundamental aspects you should further research:

1. Financial Health: Does DOW 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.

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: Are there other high quality stocks you could be holding instead of DOW? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!