In this article, we’ll estimate the intrinsic value of Western Digital Corporation (NASDAQ: WDC) by taking expected future cash flows and discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.
There are many ways that businesses can be assessed, so we would like to stress that a DCF is not perfect for all situations. Anyone who wants to know a little more about intrinsic value should have read the Simply Wall St analysis model.
Check out our latest analysis for Western Digital
What is the estimated valuation?
We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 1.12 billion||2.13 billion US dollars||US $ 2.25 billion||US $ 1.49 billion||US $ 1.93 billion||US $ 1.85 billion||US $ 1.80 billion||US $ 1.78 billion||US $ 1.78 billion||US $ 1.79 billion|
|Source of estimated growth rate||Analyst x5||Analyst x5||Analyst x2||Analyst x1||Analyst x1||Is @ -4.28%||East @ -2.4%||Is @ -1.08%||East @ -0.16%||East @ 0.49%|
|Present value (in millions of dollars) discounted at 8.4%||US $ 1.0k||US $ 1.8k||US $ 1.8k||US $ 1.1k||1.3k USD||US $ 1.1k||US $ 1.0k||US $ 937||US $ 863||US $ 801|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 12 billion
We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 8.4%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US $ 1.8B × (1 + 2.0%) ÷ (8.4% – 2.0%) = US $ 29B
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 29 billion ÷ (1 + 8.4%)ten= US $ 13 billion
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is US $ 25 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of US $ 70.0, the company appears to be roughly at fair value at a 13% discount from where the stock price is currently trading. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Because we view Western Digital 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 takes into account debt. In this calculation, we used 8.4%, which is based on a leveraged beta of 1.351. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
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 business. It is not possible to achieve a rock-solid valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Western Digital, there are three additional things you need to assess:
- Risks: For example, we have identified 2 warning signs for Western Digital (1 is a little worrying) you should be aware of.
- Future benefits: How does WDC’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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