Are Investors Undervaluing Talgo, S.A. (BME:TLGO) By 30%?

In this article we are going to estimate the intrinsic value of Talgo, S.A. (BME:TLGO) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Talgo

Crunching the numbers

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. 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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (€, Millions)	€101.5m	€87.9m	€80.1m	€75.3m	€72.4m	€70.6m	€69.6m	€69.2m	€69.0m	€69.2m
Growth Rate Estimate Source	Analyst x5	Analyst x4	Est @ -8.94%	Est @ -5.96%	Est @ -3.88%	Est @ -2.42%	Est @ -1.39%	Est @ -0.68%	Est @ -0.18%	Est @ 0.17%
Present Value (€, Millions) Discounted @ 9.3%	€92.8	€73.6	€61.3	€52.7	€46.3	€41.3	€37.3	€33.9	€30.9	€28.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €498m

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. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 9.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = €69m× (1 + 1.0%) ÷ (9.3%– 1.0%) = €837m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €837m÷ ( 1 + 9.3%)¹⁰= €343m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €841m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of €4.8, the company appears quite undervalued at a 30% 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.

The 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 Talgo 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 9.3%, which is based on a levered beta of 1.331. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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. Why is the intrinsic value higher than the current share price? For Talgo, we've compiled three further aspects you should further examine:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Talgo .
2. Future Earnings: How does TLGO'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 Spanish 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. 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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