Key Insights
Illinois Tool Works’ estimated fair value is US$254 based on 2 Stage Free Cash Flow to Equity
Illinois Tool Works’ US$252 share price indicates it is trading at similar levels as its fair value estimate
Analyst price target for ITW is US$249 which is 2.1% below our fair value estimate
Today we will run through one way of estimating the intrinsic value of Illinois Tool Works Inc. (NYSE:ITW) by taking the forecast future cash flows of the company and discounting them back to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you’d imagine.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
View our latest analysis for Illinois Tool Works
The Method
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$3.18b
US$3.49b
US$3.63b
US$3.63b
US$3.66b
US$3.71b
US$3.77b
US$3.85b
US$3.93b
US$4.01b
Growth Rate Estimate Source
Analyst x7
Analyst x3
Analyst x2
Analyst x1
Est @ 0.84%
Est @ 1.34%
Est @ 1.69%
Est @ 1.93%
Est @ 2.10%
Est @ 2.22%
Present Value ($, Millions) Discounted @ 6.8%
US$3.0k
US$3.1k
US$3.0k
US$2.8k
US$2.6k
US$2.5k
US$2.4k
US$2.3k
US$2.2k
US$2.1k
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$26b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.5%) 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 6.8%.
Story continues
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$4.0b× (1 + 2.5%) ÷ (6.8%– 2.5%) = US$96b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$96b÷ ( 1 + 6.8%)10= US$50b
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$76b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$252, the company appears about fair value at a 1.0% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
dcf
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don’t agree with these result, have a go at the calculation yourself and play with the assumptions. 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 Illinois Tool Works 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 6.8%, which is based on a levered beta of 1.042. 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.
SWOT Analysis for Illinois Tool Works
Strength
Weakness
Opportunity
Threat
Moving On:
Whilst important, the DCF calculation ideally won’t be the sole piece of analysis you scrutinize for a company. It’s not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to “what assumptions need to 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 significantly impact the valuation. For Illinois Tool Works, we’ve put together three pertinent aspects you should look at:
Risks: Consider for instance, the ever-present spectre of investment risk. We’ve identified 1 warning sign with Illinois Tool Works , and understanding this should be part of your investment process.
Future Earnings: How does ITW’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 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. 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.
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.
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Publish date : 2024-09-15 00:00:00
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