Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of Air Arabia PJSC (DFM:AIRARABIA) as an investment opportunity by taking cash flow expected futures and discounting them to the present value. Our analysis will use 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.

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We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for 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 need to discount the sum of these future cash flows to arrive at an estimate of present value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = Ï.å6.9b

After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 9.0%. We discount terminal cash flows to present value at a cost of equity of 13%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = Ï.å1.2b× (1 + 9.0%) ÷ (13%– 9.0%) = ï.å35b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= Ï.å35b÷ ( 1 + 13%)^ten= Ï.å10b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is د.إ17b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of د.إ2.1, the company appears to be pretty good value at a 43% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.

The hypotheses

We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Air Arabia PJSC 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 13%, which is based on a leveraged beta of 0.811. 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.

Look forward:

Although the valuation of a business is important, it will ideally not be the only piece of analysis you will look at for a business. The DCF model is not a perfect stock valuation tool. Instead, the best use of 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 have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For Air Arabia PJSC, we’ve rounded up three more things you should explore:

1. Risks: You should be aware of the 3 warning signs for Air Arabia PJSC (1 should not be ignored!) that we discovered before considering an investment in the company.
2. Future earnings: How does AIRARABIA’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. 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 UAE stock daily, so if you want to find the intrinsic value of any other stock, just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.