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With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. For instance, while my relative valuation model tells me James Hardie Industries plc’s (ASX:JHX) is overvalued by 42.92%, my discounted cash flow (DCF) model signals a 177.12% overvaluation instead. So, which valuation methodology should I listen to and why?
View our latest analysis for James Hardie Industries
A closer look at intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. After discounting the sum of JHX’s future FCFs by 8.55%, it’s equity value comes to A$3.64B. After dividing this by 441.52M shares outstanding, we get a target share price of A$8.25. This means that broker analysts think JHX is currently trading above its true value at A$22.87. Take a look at how I arrived at this intrinsic value here.,
But how accurate is this figure? Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. JHX’s final year FCF growth rate of -0.13%, is too low. If this assumption held true, JHX would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. However, the trade-off is that there are less analyst forecasts the further in the future we go.
A closer look at relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to JHX to compare it against. As such, I’ve used the overall Basic Materials industry as JHX’s proxy. To calculate the “true” value of JHX, we multiply JHX’s earnings by the industry’s P/E ratio to obtain a share price of A$13.05, which means JHX is overvalued. But is this a dependable conclusion?