Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Hargreaves Services Plc (LON:HSP) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.
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 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.
What's the estimated valuation?
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate
|Levered FCF (£, Millions)||-UK£3.09m||UK£13.3m||UK£13.6m||UK£13.8m||UK£14.0m||UK£14.2m||UK£14.4m||UK£14.5m||UK£14.7m||UK£14.8m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ 2.12%||Est @ 1.76%||Est @ 1.51%||Est @ 1.33%||Est @ 1.21%||Est @ 1.12%||Est @ 1.06%||Est @ 1.02%|
|Present Value (£, Millions) Discounted @ 7.9%||-UK£2.9||UK£11.4||UK£10.8||UK£10.2||UK£9.6||UK£9.0||UK£8.4||UK£7.9||UK£7.4||UK£6.9|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£78m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 0.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.9%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£15m× (1 + 0.9%) ÷ (7.9%– 0.9%) = UK£214m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£214m÷ ( 1 + 7.9%)10= UK£99m
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£177m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£4.8, the company appears about fair value at a 12% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 Hargreaves Services 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 7.9%, 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.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Hargreaves Services, there are three additional aspects you should further research:
- Risks: Take risks, for example - Hargreaves Services has 2 warning signs we think you should be aware of.
- Future Earnings: How does HSP'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: 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 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. 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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