Calculating the fair value of Xylem Inc. (NYSE:XYL)

Key findings

• Using the 2-step free cash flow to equity, the estimated fair value of Xylem is $130.
• Xylem’s share price of $141 suggests that the price is at a similar level to the estimated fair value
• The analyst price target for XYL is $150, which is 15% above our fair value estimate.

How far is Xylem Inc. (NYSE:XYL) from its intrinsic value? Using the most recent financial data, we will check if the stock is fairly valued by estimating the company’s future cash flows and discounting them to their current value using the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too difficult to follow as you’ll see from our example!

However, keep in mind that there are many ways to estimate the value of a company, and a DCF is just one of them. If you want to learn more about intrinsic value, you should check out Simply Wall St’s analysis model.

Check out our latest analysis for Xylem

Step by step through the calculation

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally speaking, the first stage is one of higher growth, and the second stage is one of lower growth. The first stage requires us to estimate the company’s cash flows for 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, we need to discount the sum of these future cash flows to arrive at an estimate of present value:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 11 billion US dollars

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. For various reasons, a very conservative growth rate is used that cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.4%) 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 7.1%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = 1.9 billion US dollars × (1 + 2.4%) ÷ (7.1% – 2.4%) = 42 billion US dollars

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 42 billion US dollars ÷ ( 1 + 7.1 %)¹⁰= 21 billion US dollars

The total value or equity value is then the sum of the present value of future cash flows, which in this case is $32 billion. The final step is to divide the equity value by the number of shares outstanding. Relative to the current share price of $141, the company is roughly at fair value at the time of writing. However, valuations are imprecise instruments, much like a telescope – move a few degrees and you end up in another galaxy. Keep this in mind.

The assumptions

We should point out that the key inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, and therefore does not provide a complete picture of a company’s potential performance. Since we view Xylem 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 takes debt into account. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.035. Beta is a measure of a stock’s volatility relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT analysis for Xylem

Looking ahead:

While a company’s valuation is important, it shouldn’t be the only metric you consider when researching a company. The DCF model is not a perfect stock valuation tool. It should be viewed more as a guide to “what assumptions need to be true for this stock to be under/overvalued.” For example, slightly adjusting the terminal value growth rate can dramatically change the overall result. With Xylem, there are three additional elements you should further investigate:

1. Risks: We think you should 1 warning signal for xylem We indicated this before investing in the company.
2. management:Have insiders increased their shares to capitalize on market sentiment regarding XYL’s future prospects? Read our management and board analysis with insights into CEO compensation and governance factors.
3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app runs 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.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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