Step by step through the calculation
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. To begin with we have to get estimates of the next five years of cash flows. 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 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)||£59.01||£62.93||£59.79||£51.80||£52.74|
|Source||Analyst x6||Analyst x7||Analyst x7||Analyst x1||Extrapolated @ (1.81%)|
|Present Value Discounted @ 8.28%||£54.50||£53.68||£47.10||£37.68||£35.43|
Present Value of 5-year Cash Flow (PVCF)= UK£228.39m
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 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = UK£52.74m × (1 + 1.4%) ÷ (8.3% – 1.4%) = UK£777.00m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = UK£777.00m ÷ ( 1 + 8.3%)5 = UK£522.03m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is UK£750.42m. The last step is to then 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) then we use the equivalent number. This results in an intrinsic value of £1.27. Relative to the current share price of £1.33, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
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. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at SIG 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.
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. For SHI, I’ve put together three relevant aspects you should look at:
- Financial Health: Does SHI 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 SHI’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 SHI? 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.