The calculation
I’m 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 perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF ($, Millions) | $49.70 | $57.55 | $72.40 | $78.10 | $84.30 |
| Source | Analyst x4 | Analyst x2 | Analyst x1 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 8.49% | $45.81 | $48.89 | $56.69 | $56.37 | $56.08 |
Present Value of 5-year Cash Flow (PVCF)= $264
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.5%. We discount this to today’s value at a cost of equity of 8.5%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $84 × (1 + 2.5%) ÷ (8.5% – 2.5%) = $1,434
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $1,434 / ( 1 + 8.5%)5 = $954
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is $1,218. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of $55.79, which, compared to the current share price of $51.75, we see that US Ecology is about right, perhaps slightly undervalued at a 7.24% discount to what it is available for right now.
Important assumptions
I’d like to point out that 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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at US Ecology as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.5%, which is based on a levered beta of 0.8. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For ECOL, I’ve put together three pertinent aspects you should look at:
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NASDAQ every 6 hours. If you want to find the calculation for other stocks just search here.
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