Question

Huxley Building Supplies' last free cash flow was $1.75 million. Its free cash flow growth rate is expected to be constant at 25% for 2 years, after which free cash flows are expected to grow at a rate of 6% forever. Its weighted average cost of capital WACC is 12%. Huxley has $5 million in short-term investments and $7 million in debt and has 1 million shares outstanding. What is the best estimate of the current intrinsic stock price?

Answer 1

Answer:

Ans. The best estimate of the current intrinsic stock price is $36.51

Explanation:

Hi, first, we have to determine the cash flows for year 1 and 2 (when the stock grows at 25%) and then, the terminal value (using the constant growth rate of 6%). Then we have to bring to present value all the cash flows (terminal value included) and since the terminal value is an amount of money expressed in dollars of year 2, we have to bring it to present value, discounted at the WACC.

Normally, we need to use the rate of return of the equity but in this case this is not possible due to the lack of information. What we can do is to find the value of the company´s equity, which means that If we bring to present value tha cash flows of year 1 and 2 and the terminal value (using thte WACC as a discount rate) and add the short term invesments and substract the debt of the company, we can find the equity´s value and divide it by the outstanding shares, therefore obtaining a good aproximation to the intrinsic value of the stock. It all goes like this.

Note. Notice that 1.75 millions were the last cash flow so we need to find the cash flow for year 1 (CF1)

$(PV)CF1=\frac{1.75(1+0.25)}{(1+0.12)^{1} } =1.9531$

$(PV)CF2=\frac{1.75(1+0.25)^{2} }{(1+0.12)^{2} } =1.9463$

$(P.V)Terminal Value=\frac{1.75(1+0.25)^{2}(1+0.06) }{(0.12-0.06)} *(\frac{1}{(1+0.12)^{2} } )=38.51$

Where (PV) means present value.

Now, let´s do the following operation

$EquityValue=(PV)allCashFlows+ShortTermInvest-Debt$

$EquityValue=(1.9531+1.9463+38.51)+5-7=36.51$

Then, the equity´s value is $36.51 millions.

Now, the intrinsic value of the stock is the value of its equity divided by the number of outstanding shares.

$Intrinsic ValueStock=\frac{36.51}{1} =36.51$

So, the intrinsic value of Huxley Building Supplies' is $36.51

Best of luck.