Is D.R. Horton, Inc. (NYSE:DHI) Trading At A 23% Discount?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, D.R. Horton fair value estimate is US$182

• D.R. Horton's US$139 share price signals that it might be 23% undervalued

• Analyst price target for DHI is US$170 which is 6.5% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of D.R. Horton, Inc. (NYSE:DHI) 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. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

View our latest analysis for D.R. Horton

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$2.94b	US$3.22b	US$3.81b	US$4.53b	US$4.39b	US$4.34b	US$4.33b	US$4.35b	US$4.40b	US$4.47b
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x4	Analyst x2	Analyst x1	Est @ -1.29%	Est @ -0.19%	Est @ 0.58%	Est @ 1.12%	Est @ 1.50%
Present Value ($, Millions) Discounted @ 8.4%	US$2.7k	US$2.7k	US$3.0k	US$3.3k	US$2.9k	US$2.7k	US$2.5k	US$2.3k	US$2.1k	US$2.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$26b

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 (2.4%) 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 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$4.5b× (1 + 2.4%) ÷ (8.4%– 2.4%) = US$76b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$76b÷ ( 1 + 8.4%)¹⁰= US$34b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$60b. 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$139, the company appears a touch undervalued at a 23% 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

Important Assumptions

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 D.R. Horton 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 8.4%, which is based on a levered beta of 1.316. 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 D.R. Horton

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Consumer Durables 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:

Whilst important, the DCF calculation is only one of many factors that you need to assess 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. Why is the intrinsic value higher than the current share price? For D.R. Horton, we've compiled three pertinent elements you should further examine:

1. Risks: Take risks, for example - D.R. Horton has 1 warning sign we think you should be aware of.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for DHI's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com