Calculating The Fair Value Of BAE Systems plc (LON:BA.)

In this article I am going to calculate the intrinsic value of BAE Systems plc (LON:BA.) by projecting its future cash flows and then discounting them to today's value. I will be using the Discounted Cash Flows (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not June 2018 then I highly recommend you check out the latest calculation for BAE Systems by following the link below. View out our latest analysis for BAE Systems

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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

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%.

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is UK£23.87b. 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 £7.48. Compared to the current share price of £6.45, the stock is about right, perhaps slightly undervalued at a 13.73% discount to what it is available for right now.

Important assumptions

I'd like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 BAE Systems 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:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For BA., I've compiled three relevant factors you should look at:

1. Financial Health: Does BA. 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. Future Earnings: How does BA.'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of BA.? 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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.