The calculation
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 five years of cash flows. Where possible I use analyst 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 five years, but capped at a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF (€, Millions) | €22.20 | €24.90 | €25.73 | €26.58 | €27.46 |
| Source | Analyst x1 | Analyst x3 | Extrapolated @ (3.32%) | Extrapolated @ (3.32%) | Extrapolated @ (3.32%) |
| Present Value Discounted @ 8.18% | €20.52 | €21.28 | €20.32 | €19.40 | €18.53 |
Present Value of 5-year Cash Flow (PVCF)= €100
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (0.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.2%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = €27 × (1 + 0.9%) ÷ (8.2% – 0.9%) = €382
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = €382 / ( 1 + 8.2%)5 = €257
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is €357. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of €49.77, which, compared to the current share price of €35.25, we find that Linedata Services is about right, perhaps slightly undervalued at a 29.18% discount to what it is available for right now.
The assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Linedata Services as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.2%, which is based on a levered beta of 0.8. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For LIN, I’ve put together three relevant aspects you should further research:
- Financial Health: Does LIN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does LIN’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of LIN? 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 for every stock on the ENXTPA every 6 hours. If you want to find the calculation for other stocks just search here.