Ocado Group plc's (LON:OCDO) Intrinsic Value Is Potentially 25% Below Its Share Price

Key Insights

• The projected fair value for Ocado Group is UK£2.28 based on 2 Stage Free Cash Flow to Equity
• Ocado Group is estimated to be 34% overvalued based on current share price of UK£3.05
• Analyst price target for OCDO is UK£4.64, which is 103% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of Ocado Group plc (LON:OCDO) by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Ocado Group

Step By Step Through 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (£, Millions)	-UK£223.3m	-UK£245.3m	-UK£114.0m	-UK£64.0m	UK£50.0m	UK£78.0m	UK£109.0m	UK£140.1m	UK£169.0m	UK£194.4m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x1	Analyst x1	Analyst x1	Est @ 55.97%	Est @ 39.81%	Est @ 28.50%	Est @ 20.58%	Est @ 15.04%
Present Value (£, Millions) Discounted @ 7.1%	-UK£209	-UK£214	-UK£92.9	-UK£48.7	UK£35.5	UK£51.7	UK£67.6	UK£81.1	UK£91.3	UK£98.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -UK£139m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = UK£194m× (1 + 2.1%) ÷ (7.1%– 2.1%) = UK£4.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£4.0b÷ ( 1 + 7.1%)¹⁰= UK£2.0b

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£1.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£3.1, the company appears potentially overvalued 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.

The Assumptions

Now 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 Ocado 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 7.1%, which is based on a levered beta of 1.024. 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.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price exceeding the intrinsic value? For Ocado Group, we've put together three pertinent elements you should look at:

1. Risks: Every company has them, and we've spotted 1 warning sign for Ocado Group you should know about.
2. Future Earnings: How does OCDO'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE 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.