In this article we are going to estimate the intrinsic value of BorgWarner Inc. (NYSE:BWA) by estimating the company’s future cash flows and discounting them to their present value. Our analysis will employ 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.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF ($, Millions)||US$825.2m||US$1.06b||US$1.17b||US$1.42b||US$1.43b||US$1.45b||US$1.47b||US$1.49b||US$1.51b||US$1.54b|
|Growth Rate Estimate Source||Analyst x9||Analyst x7||Analyst x5||Analyst x2||Analyst x1||Est @ 1.07%||Est @ 1.36%||Est @ 1.57%||Est @ 1.71%||Est @ 1.81%|
|Present Value ($, Millions) Discounted @ 11%||US$746||US$863||US$865||US$949||US$864||US$790||US$723||US$664||US$611||US$562|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.6b
The second stage is also known as Terminal Value, this is the business’s cash flow after 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 (2.0%) 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 11%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.5b× (1 + 2.0%) ÷ (11%– 2.0%) = US$18b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$18b÷ ( 1 + 11%)10= US$6.7b
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$14b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$46.5, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own 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 BorgWarner 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 11%, which is based on a levered beta of 1.640. 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.
Although the valuation of a company is…