Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of The Sherwin-Williams Company (NYSE:SHW) as an investment opportunity by taking the flows of expected future cash flows and discounting them to the present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check out our latest analysis for Sherwin-Williams
The model
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. 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.
A DCF is based on the idea that a dollar in the future is worth less 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) Forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF ($, millions) | $2.48 billion | $2.88 billion | $2.96 billion | US$3.17 billion | US$3.33 billion | $3.47 billion | $3.59 billion | $3.70 billion | $3.80 billion | $3.90 billion |
Growth rate estimate Source | Analyst x11 | Analyst x7 | Analyst x1 | Analyst x1 | Is at 5.13% | Is at 4.17% | Is at 3.5% | East @ 3.03% | Is at 2.7% | Is at 2.48% |
Present value (millions of dollars) discounted at 6.3% | $2,300 | $2,600 | $2.5,000 | $2.5,000 | $2.5,000 | $2,400 | $2,300 | $2,300 | $2,200 | $2,100 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $24 billion
The second stage is also known as the terminal value, it is the cash flow of the business after 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 1.9%. We discount terminal cash flows to present value at a cost of equity of 6.3%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = US$3.9 billion × (1 + 1.9%) ÷ (6.3%–1.9%) = US$90 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $90 billion ÷ (1 + 6.3%)^{ten}= $49 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $73 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US$236, the company appears to be about fair value at a 16% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
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. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Sherwin-Williams 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 factors in debt. In this calculation, we used 6.3%, which is based on a leveraged beta of 1.036. 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.
Let’s move on :
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For Sherwin-Williams, we’ve rounded up three essentials you should consider:
- Risks: Take for example the ubiquitous specter of investment risk. We have identified 1 warning sign with Sherwin-Williams, and understanding this should be part of your investment process.
- Future earnings: How does SHW’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.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, 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.
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