Is There An Opportunity With First Advantage Corporation's (NASDAQ:FA) 38% Undervaluation?

First Advantage Corp. -0.30% Post

First Advantage Corp.

FA

16.48

16.48

-0.30%

0.00% Post

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, First Advantage fair value estimate is US$26.11
  • Current share price of US$16.22 suggests First Advantage is potentially 38% undervalued
  • The US$18.08 analyst price target for FA is 31% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of First Advantage Corporation (NASDAQ:FA) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for First Advantage

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. 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, 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

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF ($, Millions) US$145.4m US$182.0m US$183.4m US$185.6m US$188.5m US$191.8m US$195.5m US$199.5m US$203.7m US$208.1m
Growth Rate Estimate Source Analyst x2 Analyst x3 Est @ 0.77% Est @ 1.23% Est @ 1.55% Est @ 1.77% Est @ 1.93% Est @ 2.03% Est @ 2.11% Est @ 2.16%
Present Value ($, Millions) Discounted @ 6.8% US$136 US$160 US$151 US$143 US$136 US$130 US$124 US$118 US$113 US$108

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.3b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.3%) 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%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$208m× (1 + 2.3%) ÷ (6.8%– 2.3%) = US$4.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$4.8b÷ ( 1 + 6.8%)10= US$2.5b

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$3.8b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$16.2, the company appears quite good value at a 38% 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
NasdaqGS:FA Discounted Cash Flow March 30th 2024

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. 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 First Advantage 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 0.973. 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 First Advantage

Strength
  • Debt is well covered by cash flow.
Weakness
  • Earnings declined over the past year.
  • Interest payments on debt are not well covered.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Annual revenue is forecast to grow slower than the American market.

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For First Advantage, we've compiled three important factors you should consider:

  1. Risks: For example, we've discovered 1 warning sign for First Advantage that you should be aware of before investing here.
  2. Future Earnings: How does FA'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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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