Estimating The Fair Value Of James Latham plc (LON:LTHM)

How far off is James Latham plc (LON:LTHM) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

Check out our latest analysis for James Latham

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (£, Millions)	UK£13.7m	UK£14.1m	UK£14.4m	UK£14.7m	UK£14.9m	UK£15.1m	UK£15.3m	UK£15.5m	UK£15.6m	UK£15.8m
Growth Rate Estimate Source	Est @ 3.41%	Est @ 2.66%	Est @ 2.14%	Est @ 1.77%	Est @ 1.52%	Est @ 1.34%	Est @ 1.21%	Est @ 1.13%	Est @ 1.06%	Est @ 1.02%
Present Value (£, Millions) Discounted @ 6.8%	UK£12.9	UK£12.4	UK£11.8	UK£11.3	UK£10.7	UK£10.2	UK£9.7	UK£9.1	UK£8.7	UK£8.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£104m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 0.9%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK£16m× (1 + 0.9%) ÷ (6.8%– 0.9%) = UK£272m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£272m÷ ( 1 + 6.8%)¹⁰= UK£141m

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£245m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£11.2, the company appears about fair value at a 10% 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 James Latham 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 6.8%, which is based on a levered beta of 1.104. 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:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 James Latham, we've put together three pertinent items you should assess:

1. Financial Health: Does LTHM 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.
2. 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!
3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM 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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