Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Aggreko Plc (LON:AGK) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
What's the estimated valuation?
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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£61.4m||UK£59.3m||UK£47.4m||UK£104.4m||UK£123.5m||UK£137.2m||UK£148.3m||UK£157.1m||UK£164.1m||UK£169.7m|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Analyst x2||Analyst x1||Analyst x1||Est @ 11.1%||Est @ 8.07%||Est @ 5.95%||Est @ 4.46%||Est @ 3.43%|
|Present Value (£, Millions) Discounted @ 7.5%||UK£57.1||UK£51.3||UK£38.2||UK£78.2||UK£86.0||UK£88.9||UK£89.4||UK£88.1||UK£85.6||UK£82.3|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£744m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£170m× (1 + 1.0%) ÷ (7.5%– 1.0%) = UK£2.6b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£2.6b÷ ( 1 + 7.5%)10= UK£1.3b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£2.0b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£8.4, the company appears around fair value at the time of writing. 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.
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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Aggreko 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 7.5%, which is based on a levered beta of 1.091. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. For Aggreko, we've compiled three pertinent items you should assess:
- Risks: To that end, you should learn about the 3 warning signs we've spotted with Aggreko (including 1 which shouldn't be ignored) .
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AGK's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. 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.
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