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General Dynamics Corporation (NYSE:GD) Shares Could Be 38% Below Their Intrinsic Value Estimate
Today we will run through one way of estimating the intrinsic value of General Dynamics Corporation (NYSE:GD) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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, 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
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$4.49b
US$4.75b
US$4.70b
US$4.96b
US$5.09b
US$5.23b
US$5.36b
US$5.50b
US$5.64b
US$5.79b
Growth Rate Estimate Source
Analyst x9
Analyst x8
Analyst x2
Analyst x2
Est @ 2.74%
Est @ 2.67%
Est @ 2.62%
Est @ 2.58%
Est @ 2.56%
Est @ 2.54%
Present Value ($, Millions) Discounted @ 6.1%
US$4.2k
US$4.2k
US$3.9k
US$3.9k
US$3.8k
US$3.7k
US$3.6k
US$3.4k
US$3.3k
US$3.2k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$37b
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 (2.5%) 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 6.1%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$167b÷ ( 1 + 6.1%)10= US$93b
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$130b. 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$293, the company appears quite undervalued at a 38% 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.
dcf
The Assumptions
We would point out that 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 General Dynamics 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 6.1%, which is based on a levered beta of 0.864. 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 General Dynamics
Strength
Earnings growth over the past year exceeded its 5-year average.
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Earnings growth over the past year underperformed the Aerospace & Defense industry.
Dividend is low compared to the top 25% of dividend payers in the Aerospace & Defense market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to grow slower than the American market.
Looking Ahead:
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price sitting below the intrinsic value? For General Dynamics, we've compiled three further elements you should look at:
Future Earnings: How does GD'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.
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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.
