Estimating The Fair Value Of Grafton Group plc (LON:GFTU)

Does the October share price for Grafton Group plc (LON:GFTU) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. This will be done using 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 Grafton Group

Crunching The Numbers

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. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£145.1m	UK£139.6m	UK£136.5m	UK£134.8m	UK£134.0m	UK£133.9m	UK£134.2m	UK£134.8m	UK£135.6m	UK£136.6m
Growth Rate Estimate Source	Analyst x7	Analyst x6	Est @ -2.2%	Est @ -1.24%	Est @ -0.57%	Est @ -0.1%	Est @ 0.22%	Est @ 0.45%	Est @ 0.62%	Est @ 0.73%
Present Value (£, Millions) Discounted @ 8.0%	UK£134	UK£120	UK£108	UK£99.2	UK£91.3	UK£84.5	UK£78.5	UK£73.0	UK£68.0	UK£63.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£920m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.0%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£137m× (1 + 1.0%) ÷ (8.0%– 1.0%) = UK£2.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£2.0b÷ ( 1 + 8.0%)¹⁰= UK£919m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£1.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£7.0, the company appears about fair value at a 14% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

The 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 these result, have a go at the calculation yourself and play with the 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 Grafton 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 8.0%, which is based on a levered beta of 1.255. 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.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Grafton Group, we've compiled three further elements you should explore:

1. Risks: For instance, we've identified 2 warning signs for Grafton Group (1 is potentially serious) you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for GFTU's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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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This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.