Is Norfolk Southern Corporation (NYSE:NSC) Expensive For A Reason? A Look At Its Intrinsic Value

Today we will run through one way of estimating the intrinsic value of Norfolk Southern Corporation (NYSE:NSC) by projecting its future cash flows and then discounting them to today's 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.

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.

See our latest analysis for Norfolk Southern

Is Norfolk Southern fairly valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF ($, Millions)	US$2.77b	US$2.97b	US$3.23b	US$3.02b	US$2.90b	US$2.84b	US$2.82b	US$2.82b	US$2.84b	US$2.87b
Growth Rate Estimate Source	Analyst x9	Analyst x4	Analyst x3	Analyst x2	Est @ -3.79%	Est @ -2.05%	Est @ -0.84%	Est @ 0.01%	Est @ 0.6%	Est @ 1.02%
Present Value ($, Millions) Discounted @ 7.3%	US$2.6k	US$2.6k	US$2.6k	US$2.3k	US$2.0k	US$1.9k	US$1.7k	US$1.6k	US$1.5k	US$1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$20b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US$2.9b× (1 + 2.0%) ÷ (7.3%– 2.0%) = US$56b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$56b÷ ( 1 + 7.3%)¹⁰= US$28b

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$48b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$247, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The 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. 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 Norfolk Southern 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 1.116. 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:

Although the valuation of a company is important, 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. 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. Can we work out why the company is trading at a premium to intrinsic value? For Norfolk Southern, we've compiled three important elements you should assess:

1. Risks: Case in point, we've spotted 1 warning sign for Norfolk Southern you should be aware of.

2. Future Earnings: How does NSC'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.

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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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