Stock Analysis

Is There An Opportunity With Ashtead Group plc's (LON:AHT) 46% Undervaluation?

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LSE:AHT
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How far off is Ashtead Group plc (LON:AHT) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

Check out our latest analysis for Ashtead Group

Crunching the numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.

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) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (£, Millions) UK£1.27b UK£724.9m UK£668.1m UK£684.7m UK£2.00b UK£2.50b UK£2.87b UK£3.17b UK£3.42b UK£3.61b
Growth Rate Estimate Source Analyst x10 Analyst x7 Analyst x9 Analyst x3 Analyst x1 Analyst x1 Est @ 14.75% Est @ 10.6% Est @ 7.7% Est @ 5.66%
Present Value (£, Millions) Discounted @ 7.3% UK£1.2k UK£630 UK£541 UK£517 UK£1.4k UK£1.6k UK£1.8k UK£1.8k UK£1.8k UK£1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£13b

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 7.3%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£3.6b× (1 + 0.9%) ÷ (7.3%– 0.9%) = UK£57b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£57b÷ ( 1 + 7.3%)10= UK£28b

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£42b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£50.0, the company appears quite undervalued at a 46% 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.

dcf
LSE:AHT Discounted Cash Flow June 19th 2021

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 Ashtead 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 7.3%, which is based on a levered beta of 1.196. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Ashtead Group, we've put together three pertinent elements you should look at:

  1. Risks: You should be aware of the 1 warning sign for Ashtead Group we've uncovered before considering an investment in the company.
  2. Future Earnings: How does AHT'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

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