The calculation
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. 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 estimate
2018 | 2019 | 2020 | 2021 | 2022 | |
Levered FCF (£, Millions) | £19.93 | £20.30 | £22.60 | £24.13 | £25.77 |
Source | Analyst x4 | Analyst x4 | Analyst x4 | Extrapolated @ (6.79%) | Extrapolated @ (6.79%) |
Present Value Discounted @ 8.28% | £18.40 | £17.31 | £17.80 | £17.56 | £17.32 |
Present Value of 5-year Cash Flow (PVCF)= UK£88.39m
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 an annual growth rate equal to the 10-year government bond rate of 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF_{2022} × (1 + g) ÷ (r – g) = UK£25.77m × (1 + 1.4%) ÷ (8.3% – 1.4%) = UK£379.72m
Present Value of Terminal Value (PVTV) = TV / (1 + r)^{5} = UK£379.72m ÷ ( 1 + 8.3%)^{5} = UK£255.12m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is UK£343.51m. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of £11.28. Relative to the current share price of £14, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
Important assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Avon Rubber 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 8.3%, which is based on a levered beta of 0.800. 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:
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. What is the reason for the share price to differ from the intrinsic value? For AVON, I’ve compiled three pertinent aspects you should further examine:
- Financial Health: Does AVON 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 AVON’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 AVON? 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 LON every 6 hours. If you want to find the calculation for other stocks just search here.