Key Insights

Alumina's estimated fair value is AU$2.26 based on 2 Stage Free Cash Flow to Equity Current share price of AU$1.27 suggests Alumina is potentially 44% undervalued Analyst price target for AWC is US$1.15 which is 49% below our fair value estimate

Does the March share price for Alumina Limited (ASX:AWC) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Alumina

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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$120.4m -US$15.1m US$29.0m US$127.9m US$186.3m US$232.0m US$273.3m US$309.2m US$339.6m US$365.2m Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Analyst x2 Analyst x2 Est @ 24.55% Est @ 17.83% Est @ 13.13% Est @ 9.84% Est @ 7.53% Present Value ($, Millions) Discounted @ 7.5%  -US$112 -US$13.1 US$23.3 US$95.7 US$130 US$150 US$165 US$173 US$177 US$177

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$965m

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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$365m× (1 + 2.2%) ÷ (7.5%– 2.2%) = US$7.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$7.0b÷ ( 1 + 7.5%)10= US$3.4b

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$4.3b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$1.3, the company appears quite undervalued at a 44% 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

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Alumina 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 7.5%, which is based on a levered beta of 1.165. 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 Alumina

Strength

Net debt to equity ratio below 40%.

Weakness

No major weaknesses identified for AWC.

Opportunity

Forecast to reduce losses next year.

Has sufficient cash runway for more than 3 years based on current free cash flows.

Trading below our estimate of fair value by more than 20%.

Threat

Debt is not well covered by operating cash flow.

Next Steps:

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. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value? For Alumina, there are three essential factors you should assess:

Risks: For example, we've discovered 1 warning sign for Alumina that you should be aware of before investing here. Future Earnings: How does AWC's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks 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.