How far off is Baby Bunting Group Limited (ASX:BBN) 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. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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.
What's the estimated valuation?
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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF (A$, Millions)||AU$24.0m||AU$43.3m||AU$48.3m||AU$52.0m||AU$55.1m||AU$57.7m||AU$60.0m||AU$62.0m||AU$63.8m||AU$65.5m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Est @ 7.64%||Est @ 5.95%||Est @ 4.77%||Est @ 3.94%||Est @ 3.36%||Est @ 2.96%||Est @ 2.67%|
|Present Value (A$, Millions) Discounted @ 8.8%||AU$22.1||AU$36.6||AU$37.5||AU$37.1||AU$36.1||AU$34.8||AU$33.2||AU$31.6||AU$29.9||AU$28.2|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$327m
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 (2.0%) 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 8.8%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU$66m× (1 + 2.0%) ÷ (8.8%– 2.0%) = AU$985m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$985m÷ ( 1 + 8.8%)10= AU$424m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$751m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$5.7, the company appears about fair value at a 2.8% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Baby Bunting 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 8.8%, which is based on a levered beta of 1.297. 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.
Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Baby Bunting Group, we've compiled three important items you should further research:
- Risks: Take risks, for example - Baby Bunting Group has 2 warning signs we think you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BBN's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.
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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. 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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