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Does the February share price for Chemring Group PLC (LON:CHG) reflect it’s really worth? Today, I will calculate the stock’s intrinsic value by taking the expected future cash flows and discounting them to today’s value. This is done using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! 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 February 2019 then I highly recommend you check out the latest calculation for Chemring Group by following the link below.
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. 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 this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow estimate
|Levered FCF (£, Millions)||£6.70||£24.43||£32.17||£33.25||£34.37|
|Source||Analyst x3||Analyst x3||Analyst x3||Est @ 3.36%||Est @ 3.36%|
|Present Value Discounted @ 8.25%||£6.19||£20.85||£25.36||£24.22||£23.13|
Present Value of 5-year Cash Flow (PVCF)= UK£100m
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. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 1.2%. We discount this to today’s value at a cost of equity of 8.2%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = UK£34m × (1 + 1.2%) ÷ (8.2% – 1.2%) = UK£496m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = UK£496m ÷ ( 1 + 8.2%)5 = UK£334m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is UK£433m. 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 £1.55. Relative to the current share price of £1.52, the stock is about right, perhaps slightly undervalued at a 1.5% discount to what it is available for right now.
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 Chemring Group 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 0.800. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. For CHG, I’ve compiled three key aspects you should further research:
- Financial Health: Does CHG 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 CHG’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 CHG? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every GB stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. On rare occasion, data errors may occur. Thank you for reading.