Stock Analysis

Are Investors Undervaluing Burberry Group plc (LON:BRBY) By 40%?

LSE:BRBY
Source: Shutterstock

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Burberry Group fair value estimate is UK£21.25
  • Burberry Group's UK£12.86 share price signals that it might be 40% undervalued
  • The UK£16.58 analyst price target for BRBY is 22% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Burberry Group plc (LON:BRBY) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

View our latest analysis for Burberry Group

The Calculation

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF (£, Millions) UK£409.8m UK£501.1m UK£536.2m UK£561.0m UK£618.0m UK£650.1m UK£676.8m UK£699.3m UK£718.7m UK£736.0m
Growth Rate Estimate Source Analyst x9 Analyst x8 Analyst x7 Analyst x1 Analyst x1 Est @ 5.20% Est @ 4.10% Est @ 3.32% Est @ 2.78% Est @ 2.40%
Present Value (£, Millions) Discounted @ 9.3% UK£375 UK£419 UK£410 UK£393 UK£396 UK£381 UK£362 UK£342 UK£322 UK£302

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£3.7b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.5%) 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 9.3%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£736m× (1 + 1.5%) ÷ (9.3%– 1.5%) = UK£9.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£9.6b÷ ( 1 + 9.3%)10= UK£3.9b

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£7.6b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£12.9, the company appears quite good value at a 40% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
LSE:BRBY Discounted Cash Flow January 13th 2024

The 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. 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 Burberry 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 9.3%, which is based on a levered beta of 1.322. 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 Burberry Group

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Earnings growth over the past year is below its 5-year average.
  • Dividend is low compared to the top 25% of dividend payers in the Luxury market.
Opportunity
  • Annual revenue is forecast to grow faster than the British market.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Annual earnings are forecast to grow slower than the British market.

Moving On:

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. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Burberry Group, we've put together three additional factors you should further examine:

  1. Risks: We feel that you should assess the 1 warning sign for Burberry Group we've flagged before making an investment in the company.
  2. Future Earnings: How does BRBY'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 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.

Valuation is complex, but we're here to simplify it.

Discover if Burberry Group might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.

Access Free Analysis

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.