Key Insights

Using the 2 Stage Free Cash Flow to Equity, Harvey Norman Holdings fair value estimate is AU$7.61 Current share price of AU$4.71 suggests Harvey Norman Holdings is potentially 38% undervalued The AU$4.75 analyst price target for HVN is 38% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of Harvey Norman Holdings Limited (ASX:HVN) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

See our latest analysis for Harvey Norman Holdings

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. 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.

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) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 Levered FCF (A$, Millions)  AU$339.1m AU$336.2m AU$471.0m AU$489.0m AU$505.0m AU$519.1m AU$533.0m AU$546.9m AU$560.8m AU$574.9m Growth Rate Estimate Source Analyst x4 Analyst x3 Analyst x1 Analyst x1 Analyst x1 Est @ 2.80% Est @ 2.68% Est @ 2.60% Est @ 2.54% Est @ 2.50% Present Value (A$, Millions) Discounted @ 7.2%  AU$316 AU$293 AU$383 AU$371 AU$357 AU$343 AU$328 AU$314 AU$301 AU$288

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$3.3b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 7.2%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = AU$575m× (1 + 2.4%) ÷ (7.2%– 2.4%) = AU$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$12b÷ ( 1 + 7.2%)10= AU$6.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$9.5b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$4.7, the company appears quite undervalued at a 38% discount to where the stock price trades currently. 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

The 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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Harvey Norman Holdings 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 7.2%, 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 Harvey Norman Holdings

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 Multiline Retail market.

Opportunity

Annual revenue is forecast to grow faster than the Australian market.

Good value based on P/E ratio and estimated fair value.

Threat

Annual earnings are forecast to grow slower than the Australian market.

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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Harvey Norman Holdings, we've compiled three fundamental elements you should further examine:

Risks: Consider for instance, the ever-present spectre of investment risk.  We've identified 2 warning signs  with Harvey Norman Holdings , and understanding these should be part of your investment process. Future Earnings: How does HVN'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. 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.

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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.

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