Is There An Opportunity With Air Products and Chemicals, Inc.'s (NYSE:APD) 32% Undervaluation?

Key Insights

• Air Products and Chemicals' estimated fair value is US$391 based on 2 Stage Free Cash Flow to Equity

• Air Products and Chemicals is estimated to be 32% undervalued based on current share price of US$265

• Analyst price target for APD is US$271 which is 31% below our fair value estimate

How far off is Air Products and Chemicals, Inc. (NYSE:APD) 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. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

View our latest analysis for Air Products and Chemicals

What's The Estimated Valuation?

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 begin with, we have to get estimates of 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	-US$1.40b	-US$868.6m	-US$277.9m	US$1.36b	US$2.23b	US$3.25b	US$4.31b	US$5.33b	US$6.25b	US$7.05b
Growth Rate Estimate Source	Analyst x8	Analyst x7	Analyst x5	Analyst x1	Est @ 64.32%	Est @ 45.74%	Est @ 32.73%	Est @ 23.62%	Est @ 17.25%	Est @ 12.79%
Present Value ($, Millions) Discounted @ 7.3%	-US$1.3k	-US$754	-US$225	US$1.0k	US$1.6k	US$2.1k	US$2.6k	US$3.0k	US$3.3k	US$3.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$15b

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 (2.4%) 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 7.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$7.1b× (1 + 2.4%) ÷ (7.3%– 2.4%) = US$146b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$146b÷ ( 1 + 7.3%)¹⁰= US$72b

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$87b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$265, the company appears quite undervalued at a 32% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Air Products and Chemicals 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 1.074. 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 Air Products and Chemicals

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Chemicals market.

Opportunity

• Annual revenue is forecast to grow faster than the American market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Paying a dividend but company has no free cash flows.

• Annual earnings are forecast to grow slower than the American market.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. Why is the intrinsic value higher than the current share price? For Air Products and Chemicals, we've compiled three fundamental aspects you should further examine:

1. Risks: For example, we've discovered 3 warning signs for Air Products and Chemicals (1 is potentially serious!) that you should be aware of before investing here.

2. Future Earnings: How does APD'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.

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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.