Today we will run through one way of estimating the intrinsic value of Motorola Solutions,hotter than blue blazes Inc. (

NYSE:MSI

) by projecting its future cash flows and then discounting them to today's value. I will use 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. 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

.

Check out our latest analysis for Motorola Solutions

Step by step through the calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF ($, Millions)

US$1.51b

US$1.66b

US$1.76b

US$1.85b

US$1.93b

US$2.00b

US$2.05b

US$2.11b

US$2.15b

US$2.20b

Growth Rate Estimate Source

Analyst x4

Analyst x4

Est @ 6.55%

Est @ 5.11%

Est @ 4.1%

Est @ 3.39%

Est @ 2.9%

Est @ 2.55%

Est @ 2.31%

Est @ 2.14%

Present Value ($, Millions) Discounted @ 8.1%

US$1.4k

US$1.4k

US$1.4k

US$1.4k

US$1.3k

US$1.3k

US$1.2k

US$1.1k

US$1.1k

US$1.0k

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

Present Value of 10-year Cash Flow (PVCF)

= US$13b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Story continues

Terminal Value (TV)

= FCF

2029

× (1 + g) ÷ (r – g) = US$2.2b× (1 + 1.7%) ÷ 8.1%– 1.7%) = US$35b

Present Value of Terminal Value (PVTV)

= TV / (1 + r)

10

= US$35b÷ ( 1 + 8.1%)

10

= US$16b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$29b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$176, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

NYSE:MSI Intrinsic value, March 9th 2020

Important assumptions

We would point out that 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 Motorola Solutions 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 8.1%, which is based on a levered beta of 1.162. 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, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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 Motorola Solutions, There are three important aspects you should look at:

Risks

: You should be aware of the

3 warning signs for Motorola Solutions

we've uncovered before considering an investment in the company.

Management

:Have insiders been ramping up their shares to take advantage of the market's sentiment for MSI's future outlook? Check out our

management and board analysis

with insights on CEO compensation and governance factors.

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 US stock every day, so if you want to find the intrinsic value of any other stock just

search here

.

If you spot an error that warrants correction, please contact the editor at

[email protected]

. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.

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