Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Veralto Corporation (NYSE:VLTO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$972.2m
US$1.06b
US$1.17b
US$1.23b
US$1.29b
US$1.33b
US$1.38b
US$1.42b
US$1.46b
US$1.51b
Growth Rate Estimate Source
Analyst x8
Analyst x6
Analyst x2
Analyst x1
Est @ 4.16%
Est @ 3.70%
Est @ 3.37%
Est @ 3.15%
Est @ 2.99%
Est @ 2.88%
Present Value ($, Millions) Discounted @ 6.6%
US$912
US$931
US$966
US$955
US$933
US$908
US$880
US$852
US$823
US$794
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$9.0b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.6%) 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 6.6%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$39b÷ ( 1 + 6.6%)10= US$20b
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$29b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$106, the company appears about fair value at a 10% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
NYSE:VLTO Discounted Cash Flow November 24th 2024
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Veralto 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 6.6%, which is based on a levered beta of 0.969. 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 Veralto
Strength
Debt is well covered by earnings and cashflows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Commercial Services market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Current share price is below our estimate of fair value.
Threat
Annual earnings are forecast to grow slower than the American market.
Next Steps:
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Veralto, we've put together three pertinent elements you should further examine:
Risks: Take risks, for example - Veralto has 1 warning sign we think you should be aware of.
Future Earnings: How does VLTO'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 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. Simply Wall St updates its DCF calculation for every American 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.
