Today we will run through one way of estimating the intrinsic value of Big Technologies plc (LON:BIG) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (£, Millions)||UK£25.4m||UK£27.5m||UK£29.0m||UK£30.2m||UK£31.1m||UK£31.9m||UK£32.6m||UK£33.1m||UK£33.6m||UK£34.1m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 5.42%||Est @ 4.09%||Est @ 3.16%||Est @ 2.51%||Est @ 2.05%||Est @ 1.73%||Est @ 1.51%||Est @ 1.35%|
|Present Value (£, Millions) Discounted @ 6.1%||UK£23.9||UK£24.4||UK£24.3||UK£23.8||UK£23.1||UK£22.3||UK£21.5||UK£20.6||UK£19.7||UK£18.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£222m
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 6.1%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£34m× (1 + 1.0%) ÷ (6.1%– 1.0%) = UK£670m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£670m÷ ( 1 + 6.1%)10= UK£370m
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£592m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£2.6, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
Now 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 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 Big Technologies 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 6.1%, which is based on a levered beta of 0.880. 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 Big Technologies
- Currently debt free.
- Earnings growth over the past year underperformed the Commercial Services industry.
- Expensive based on P/E ratio and estimated fair value.
- Annual earnings are forecast to grow faster than the British market.
- Revenue is forecast to grow slower than 20% per year.
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. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price exceeding the intrinsic value? For Big Technologies, we've compiled three pertinent elements you should assess:
- Risks: For instance, we've identified 1 warning sign for Big Technologies that you should be aware of.
- Future Earnings: How does BIG'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 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM every day. If you want to find the calculation for other stocks 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.