Does This Valuation Of Fortescue Metals Group Limited (ASX:FMG) Imply Investors Are Overpaying?

Key Insights

• Fortescue Metals Group's estimated fair value is AU$15.66 based on 2 Stage Free Cash Flow to Equity

• Fortescue Metals Group is estimated to be 33% overvalued based on current share price of AU$20.86

• Our fair value estimate is 12% lower than Fortescue Metals Group's analyst price target of US$17.82

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Fortescue Metals Group Limited (ASX:FMG) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Fortescue Metals Group

Step By Step Through 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. 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$3.63b	US$3.11b	US$3.37b	US$3.71b	US$2.29b	US$2.20b	US$2.15b	US$2.12b	US$2.12b	US$2.13b
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x4	Analyst x3	Analyst x2	Est @ -4.16%	Est @ -2.33%	Est @ -1.06%	Est @ -0.16%	Est @ 0.47%
Present Value ($, Millions) Discounted @ 8.8%	US$3.3k	US$2.6k	US$2.6k	US$2.7k	US$1.5k	US$1.3k	US$1.2k	US$1.1k	US$994	US$918

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$2.1b× (1 + 1.9%) ÷ (8.8%– 1.9%) = US$32b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$32b÷ ( 1 + 8.8%)¹⁰= US$14b

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$32b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$20.9, the company appears reasonably expensive at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

Important 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 Fortescue Metals 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 8.8%, which is based on a levered beta of 1.155. 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 Fortescue Metals Group

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• Annual earnings are forecast to decline for the next 3 years.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 lower than the current share price? For Fortescue Metals Group, there are three fundamental elements you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Fortescue Metals Group (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for FMG'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 Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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

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.

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