In this article, we will estimate the intrinsic value of The Container Store Group, Inc. (NYSE: TCS) by estimating the company’s future cash flows and discounting them to their present value. This will be done using the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
Step by step through the calculation
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$214.0 million||$55.0 million||$13.5 million||$6.47 million||$4.15 million||$3.13 million||$2.61 million||$2.32 million||$2.15 million||$2.06 million|
|Growth rate estimate Source||Analyst x1||Analyst x1||East @ -75.39%||East @ -52.19%||Is @ -35.95%||East @ -24.58%||Is @ -16.63%||East @ -11.06%||East @ -7.16%||Is @ -4.43%|
|Present value (in millions of dollars) discounted at 9.8%||$195||$45.6||$10.2||$4.5||$2.6||$1.8||$1.4||$1.1||$0.9||$0.8|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $263 million
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 9.8%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $2.1 million × (1 + 1.9%) ÷ (9.8%–1.9%) = $27 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= $27 million ÷ (1 + 9.8%)ten= $11 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $274 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$6.6, the company appears slightly overvalued at the time of writing. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Container Store 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 takes debt into account. In this calculation, we used 9.8%, which is based on a leveraged beta of 1.846. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, 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 crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value lower than the current stock price? For Container Store Group, there are three other aspects you need to consider:
- Risks: For example, we have identified 1 warning sign for Container Store Group of which you should be aware.
- Management: Did insiders increase their shares to take advantage of market sentiment about TCS’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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