Using the 2 Stage Free Cash Flow to Equity, Advanced Drainage Systems fair value estimate is US$136
Advanced Drainage Systems' US$155 share price indicates it is trading at similar levels as its fair value estimate
Analyst price target for WMS is US$192, which is 41% above our fair value estimate
In this article we are going to estimate the intrinsic value of Advanced Drainage Systems, Inc. (NYSE:WMS) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
The Model
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$450.6m
US$591.0m
US$601.1m
US$612.6m
US$625.1m
US$638.6m
US$652.7m
US$667.5m
US$682.9m
US$698.8m
Growth Rate Estimate Source
Analyst x2
Analyst x2
Est @ 1.71%
Est @ 1.91%
Est @ 2.05%
Est @ 2.15%
Est @ 2.22%
Est @ 2.27%
Est @ 2.30%
Est @ 2.32%
Present Value ($, Millions) Discounted @ 7.7%
US$418
US$510
US$481
US$456
US$432
US$409
US$389
US$369
US$351
US$333
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$4.1b
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. 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 (2.4%) 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 7.7%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$13b÷ ( 1 + 7.7%)10= US$6.4b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$11b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$155, the company appears around fair value at the time of writing. 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:WMS Discounted Cash Flow July 3rd 2024
The 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 Advanced Drainage Systems 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 7.7%, which is based on a levered beta of 1.154. 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 Advanced Drainage Systems
Strength
Debt is well covered by earnings and cashflows.
Balance sheet summary for WMS.
Weakness
Earnings growth over the past year underperformed the Building industry.
Dividend is low compared to the top 25% of dividend payers in the Building market.
Expensive based on P/E ratio and estimated fair value.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Threat
Annual earnings are forecast to grow slower than the American market.
What else are analysts forecasting for WMS?
Looking Ahead:
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. 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. For Advanced Drainage Systems, there are three pertinent items you should further research:
Risks: You should be aware of the 2 warning signs for Advanced Drainage Systems we've uncovered before considering an investment in the company.
Future Earnings: How does WMS'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.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
