Air New Zealand Limited's (NZSE:AIR) Intrinsic Value Is Potentially 89% Above Its Share Price

How far off is Air New Zealand Limited (NZSE:AIR) 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 forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Air New Zealand

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. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (NZ$, Millions)	NZ$183.9m	NZ$174.5m	NZ$169.3m	NZ$166.8m	NZ$166.1m	NZ$166.6m	NZ$168.0m	NZ$170.1m	NZ$172.5m	NZ$175.3m
Growth Rate Estimate Source	Est @ -8.19%	Est @ -5.12%	Est @ -2.97%	Est @ -1.47%	Est @ -0.42%	Est @ 0.32%	Est @ 0.84%	Est @ 1.2%	Est @ 1.45%	Est @ 1.63%
Present Value (NZ$, Millions) Discounted @ 10%	NZ$167	NZ$143	NZ$126	NZ$113	NZ$102	NZ$92.7	NZ$84.8	NZ$77.8	NZ$71.6	NZ$65.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$1.0b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = NZ$175m× (1 + 2.0%) ÷ (10%– 2.0%) = NZ$2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$2.2b÷ ( 1 + 10%)¹⁰= NZ$817m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$1.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of NZ$0.9, the company appears quite undervalued at a 47% 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

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 Air New Zealand 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%, which is based on a levered beta of 1.942. 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Air New Zealand, there are three important factors you should further examine:

1. Risks: Be aware that Air New Zealand is showing 3 warning signs in our investment analysis , you should know about...

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AIR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. 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 New Zealander 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.