Are Investors Undervaluing AB Volvo (publ) (STO:VOLV B) By 36%?

Key Insights

• AB Volvo's estimated fair value is kr461 based on 2 Stage Free Cash Flow to Equity
• Current share price of kr295 suggests AB Volvo is potentially 36% undervalued
• Analyst price target for VOLV B is kr293 which is 36% below our fair value estimate

In this article we are going to estimate the intrinsic value of AB Volvo (publ) (STO:VOLV B) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

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The Model

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. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (SEK, Millions)	kr38.4b	kr44.2b	kr48.4b	kr51.9b	kr54.7b	kr57.1b	kr59.2b	kr60.9b	kr62.5b	kr64.0b
Growth Rate Estimate Source	Analyst x7	Analyst x6	Est @ 9.49%	Est @ 7.16%	Est @ 5.52%	Est @ 4.37%	Est @ 3.57%	Est @ 3.01%	Est @ 2.62%	Est @ 2.34%
Present Value (SEK, Millions) Discounted @ 7.3%	kr35.8k	kr38.4k	kr39.2k	kr39.1k	kr38.5k	kr37.4k	kr36.1k	kr34.7k	kr33.1k	kr31.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = kr364b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = kr64b× (1 + 1.7%) ÷ (7.3%– 1.7%) = kr1.2t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= kr1.2t÷ ( 1 + 7.3%)¹⁰= kr573b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is kr937b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of kr295, the company appears quite good value at a 36% 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.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 AB Volvo 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 7.3%, which is based on a levered beta of 1.332. 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.

Check out our latest analysis for AB Volvo

SWOT Analysis for AB Volvo

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Why is the intrinsic value higher than the current share price? For AB Volvo, we've compiled three essential aspects you should further research:

1. Risks: Take risks, for example - AB Volvo has 2 warning signs (and 1 which is a bit concerning) we think you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for VOLV B's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. 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. Simply Wall St updates its DCF calculation for every Swedish stock every day, so if you want to find the intrinsic value of any other stock 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.