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A Look At The Fair Value Of Southwest Airlines Co. (NYSE:LUV)

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Today we will run through one way of estimating the intrinsic value of Southwest Airlines Co. (NYSE:LUV) 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. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Southwest Airlines

Crunching the numbers

We're 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 a stable growth rate. 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) estimate

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF ($, Millions)

-US$87.1m

US$1.21b

US$2.54b

US$1.89b

US$1.54b

US$1.35b

US$1.24b

US$1.18b

US$1.15b

US$1.13b

Growth Rate Estimate Source

Analyst x7

Analyst x6

Analyst x2

Analyst x1

Est @ -18.37%

Est @ -12.27%

Est @ -8%

Est @ -5.01%

Est @ -2.92%

Est @ -1.46%

Present Value ($, Millions) Discounted @ 6.4%

-US$81.9

US$1.1k

US$2.1k

US$1.5k

US$1.1k

US$932

US$806

US$719

US$656

US$608

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$9.4b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.