Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Performance Food Group Company (NYSE:PFGC) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
See our latest analysis for Performance Food Group
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) forecast
|Levered FCF ($, Millions)||US$680.7m||US$813.0m||US$913.5m||US$948.0m||US$967.0m||US$985.1m||US$1.00b||US$1.02b||US$1.04b||US$1.06b|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Analyst x2||Analyst x1||Analyst x1||Est @ 1.87%||Est @ 1.90%||Est @ 1.93%||Est @ 1.94%||Est @ 1.95%|
|Present Value ($, Millions) Discounted @ 7.2%||US$635||US$707||US$741||US$717||US$683||US$648||US$616||US$586||US$557||US$530|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.4b
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. The Gordon Growth formula is used to calculate 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 today’s value at a cost of equity of 7.2%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.1b× (1 + 2.0%) ÷ (7.2%– 2.0%) = US$21b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$21b÷ ( 1 + 7.2%)10= US$10b
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$17b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$61.3, the company appears quite good value at a 43% 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Performance Food Group 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 7.2%, which is based on a levered beta of 0.871. 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 Performance Food Group
- Earnings growth over the past year exceeded the industry.
- Interest payments on debt are not well covered.
- Annual earnings are forecast to grow faster than the American market.
- Trading below our estimate of fair value by more than 20%.
- Debt is not well covered by operating cash flow.
- Annual revenue is forecast to grow slower than the American market.
Whilst important, the DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Performance Food Group, there are three pertinent aspects you should look at:
- Risks: Case in point, we’ve spotted 2 warning signs for Performance Food Group you should be aware of, and 1 of them is potentially serious.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for PFGC’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
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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.