How far off is The Sage Group plc (LON:SGE) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by estimating the company’s future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. 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. 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.
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. 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
|Levered FCF (£, Millions)||UK£321.9m||UK£362.5m||UK£387.9m||UK£384.6m||UK£382.9m||UK£382.4m||UK£382.6m||UK£383.3m||UK£384.5m||UK£385.9m|
|Growth Rate Estimate Source||Analyst x8||Analyst x9||Analyst x7||Est @ -0.85%||Est @ -0.43%||Est @ -0.14%||Est @ 0.06%||Est @ 0.2%||Est @ 0.3%||Est @ 0.37%|
|Present Value (£, Millions) Discounted @ 7.1%||UK£301||UK£316||UK£316||UK£292||UK£272||UK£254||UK£237||UK£222||UK£208||UK£195|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.6b
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 0.5%. We discount the terminal cash flows to today’s value at a cost of equity of 7.1%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£386m× (1 + 0.5%) ÷ 7.1%– 0.5%) = UK£5.9b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£5.9b÷ ( 1 + 7.1%)10= UK£3.0b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£5.6b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£5.6, 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.
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 Sage Group 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 7.1%, which is based on a levered beta of 1.080. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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 Sage Group, There are three important factors you should further research:
- Risks: To that end, you should be aware of the 2 warning signs we’ve spotted with Sage Group .
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for SGE’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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.