Are Investors Undervaluing Luceco plc (LON:LUCE) By 23%?

How far off is Luceco plc (LON:LUCE) 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. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out the opportunities and risks within the GB Electrical industry.

Step By Step Through The Calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£15.5m	UK£14.7m	UK£14.3m	UK£14.0m	UK£13.9m	UK£13.8m	UK£13.8m	UK£13.9m	UK£14.0m	UK£14.1m
Growth Rate Estimate Source	Analyst x3	Analyst x1	Est @ -2.93%	Est @ -1.76%	Est @ -0.93%	Est @ -0.36%	Est @ 0.05%	Est @ 0.33%	Est @ 0.53%	Est @ 0.67%
Present Value (£, Millions) Discounted @ 8.7%	UK£14.2	UK£12.5	UK£11.1	UK£10.1	UK£9.2	UK£8.4	UK£7.7	UK£7.2	UK£6.6	UK£6.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£93m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 8.7%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£14m× (1 + 1.0%) ÷ (8.7%– 1.0%) = UK£185m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£185m÷ ( 1 + 8.7%)¹⁰= UK£81m

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£174m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.9, the company appears a touch undervalued at a 23% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important 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 Luceco 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 8.7%, which is based on a levered beta of 1.435. 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.

SWOT Analysis for Luceco

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Luceco, we've put together three further aspects you should assess:

1. Risks: To that end, you should learn about the 4 warning signs we've spotted with Luceco (including 1 which doesn't sit too well with us) .
2. Future Earnings: How does LUCE'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: Do you like a good all-rounder? 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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.