I am going to run you through how I calculated the intrinsic value of Dignity (LSE:DTY) by estimating the Future Cash Flows and discounting them to their present value. Discounted Cash Flow or DCF is a direct valuation technique that values a company by projecting its future cash flows and then discounting them to todays money. It sounds complicated, but actually it is quite simple!Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
If you are reading this and its not August 2017 then I highly recommend you check out the latest calculation for Dignity by following the link below. View our latest analysis for Dignity
I’m 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 perpetual stable growth rate. To start off with we need to estimate the next 5 years of cash flows, where possible I use analysts estimates but when these aren’t available I have extrapolated the previous Free Cash Flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past 5 years, but capped to a reasonable level. We then discount this to its value today and sum up the total to get the present value of these cash flows.
Note the numbers here are in millions apart from the per share values.
5-year cash flow forecast
|Levered FCF (GBP, Millions)||£58.70||£63.15||£70.85||£76.20||£81.95|
|Source||Analyst x2||Analyst x2||Analyst x2||Extrapolated @ (7.55%)||Extrapolated @ (7.55%)|
|Present Value Discounted @ 8.23%||£54.23||£53.91||£55.88||£55.52||£55.17|
Present value of next 5 years cash flows: £275
The 2nd stage is also known as Terminal Value, this is the cash flows to the business after the 1st stage. For a number of reasons a very conservative rate is used that cannot exceed that of the GDP. In this case I have used the 10 year government bond rate (1.2%). In the same way as with the 5 year ‘growth’ period we discount this to today’s value.
Terminal Value = FCF2021 × (1 + g) ÷ (Discount Rate – g)
Terminal Value = £82 × (1 + 1.2%) ÷ (8.2% – 1.2%)
Terminal value based on the Perpetuity Method where growth (g) = 1.2%: £1,174
Present value of terminal value: £790
So the total value is the sum of the next 5 years cash flows and the terminal value discounted to today, this is known as the Equity Value.
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = £275 + £790 = £1,065
The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number.
Value = Total value / Shares Outstanding (£1,064.86 / 49.93)
Value per share: £21.33
To finish off with if we compare the intrinsic value of 21.33 to the current share price of £22.7 we find Dignity (LSE:DTY) is slightly overvalued at the time of writing.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Dignity as potential investors the Cost of Equity is used as the discount rate, not the Cost of Capital (or Weighed Average Cost of Capital/ WACC) which accounts for debt.
In this calculation I’ve used 8.2% and this is based on a Levered Beta of 0.8. I’m not going to go into how I calculate the Levered Beta in detail, I used the ‘Bottom up Beta’ method based on the comparable businesses, I also impose a limit between 0.8 and 2 which is a reasonable range for a stable business. Google this if you want to learn more.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. Is Dignity in a healthy financial condition? What is the reason for the share price to differ from the intrinsic value? See our latest FREE analysis to find out!
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