How far off is cavalcade of bands 2023Leidos Holdings, Inc. (

NYSE:LDOS

) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the

Simply Wall St analysis model here

may be something of interest to you.

View our latest analysis for Leidos Holdings

The method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF ($, Millions)

US$937.2m

US$971.0m

US$1.06b

US$1.08b

US$1.10b

US$1.12b

US$1.14b

US$1.17b

US$1.19b

US$1.22b

Growth Rate Estimate Source

Analyst x5

Analyst x3

Analyst x1

Est @ 1.7%

Est @ 1.85%

Est @ 1.96%

Est @ 2.04%

Est @ 2.09%

Est @ 2.13%

Est @ 2.16%

Present Value ($, Millions) Discounted @ 10.0%

US$852

US$803

US$798

US$738

US$684

US$634

US$588

US$546

US$507

US$471

("Est" = FCF growth rate estimated by Simply Wall St)

Present Value of 10-year Cash Flow (PVCF)

= US$6.6b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 10.0%.

Story continues

Terminal Value (TV)

= FCF

2030

× (1 + g) ÷ (r – g) = US$1.2b× (1 + 2.2%) ÷ (10.0%– 2.2%) = US$16b

Present Value of Terminal Value (PVTV)

= TV / (1 + r)

10

= US$16b÷ ( 1 + 10.0%)

10

= US$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 US$13b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$83.0, the company appears about fair value at a 7.9% 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

Important 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 Leidos 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 10.0%, which is based on a levered beta of 1.292. 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.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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. For Leidos Holdings, we've compiled three pertinent items you should assess:

Risks

: Every company has them, and we've spotted

1 warning sign for Leidos Holdings

you should know about.

Future Earnings

: How does LDOS'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 Solid Businesses

: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore

our interactive list of stocks with solid business fundamentals

to see if there are other companies you may not have considered!

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

search here

.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content?

Get in touch

with us directly.

Alternatively, email

[email protected]

.

View comments