Is Telefónica, S.A. (BME:TEF) Trading At A 49% Discount?

Key Insights

• Telefónica's estimated fair value is €8.70 based on 2 Stage Free Cash Flow to Equity
• Telefónica's €4.47 share price signals that it might be 49% undervalued
• Our fair value estimate is 106% higher than Telefónica's analyst price target of €4.23

How far off is Telefónica, S.A. (BME:TEF) 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. 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!

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. 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've discovered 2 warning signs about Telefónica. View them for free.

The Method

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 begin with, we have to get estimates of 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (€, Millions)	€2.43b	€2.78b	€2.92b	€3.03b	€3.12b	€3.20b	€3.28b	€3.35b	€3.43b	€3.50b
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x5	Analyst x2	Est @ 2.96%	Est @ 2.67%	Est @ 2.46%	Est @ 2.31%	Est @ 2.21%	Est @ 2.14%
Present Value (€, Millions) Discounted @ 7.8%	€2.3k	€2.4k	€2.3k	€2.2k	€2.1k	€2.0k	€1.9k	€1.8k	€1.7k	€1.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €21b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 7.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = €3.5b× (1 + 2.0%) ÷ (7.8%– 2.0%) = €61b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €61b÷ ( 1 + 7.8%)¹⁰= €29b

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 €49b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €4.5, the company appears quite undervalued at a 49% 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 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. 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 Telefónica 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 7.8%, which is based on a levered beta of 0.909. 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.

Check out our latest analysis for Telefónica

SWOT Analysis for Telefónica

Moving On:

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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Why is the intrinsic value higher than the current share price? For Telefónica, there are three pertinent aspects you should further examine:

1. Risks: As an example, we've found 2 warning signs for Telefónica (1 is concerning!) that you need to consider before investing here.
2. Future Earnings: How does TEF'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the BME 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.