Fortescue Metals Group Limited (ASX:FMG) Shares Could Be 31% Below Their Intrinsic Value Estimate

Does the July share price for Fortescue Metals Group Limited (ASX:FMG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in theSimply Wall St analysis model.

View our latest analysis for Fortescue Metals Group

The method

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

		2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
1	Levered FCF ($, Millions)	US$6.37b	US$4.25b	US$3.85b	US$3.01b	US$4.48b	US$4.50b	US$4.53b	US$4.58b	US$4.65b	US$4.72b
2	Growth Rate Estimate Source	Analyst x8	Analyst x7	Analyst x3	Analyst x2	Analyst x1	Est @ 0.32%	Est @ 0.8%	Est @ 1.14%	Est @ 1.37%	Est @ 1.54%
3	Present Value ($, Millions) Discounted @ 7.0%	US$5.9k	US$3.7k	US$3.1k	US$2.3k	US$3.2k	US$3.0k	US$2.8k	US$2.7k	US$2.5k	US$2.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= US$32b

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 (1.9%) 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 7.0%.

Terminal Value (TV)= FCF₂₀₃₁× (1 + g) ÷ (r – g) = US$4.7b× (1 + 1.9%) ÷ (7.0%– 1.9%) = US$94b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$94b÷ ( 1 + 7.0%)¹⁰= US$48b

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$79b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$23.6, the company appears quite undervalued at a 31% discount to where the stock price trades currently. 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.

ASX:FMG Discounted Cash Flow July 4th 2021