Calculating The Intrinsic Value Of Hargreaves Services Plc (LON:HSP)

Today we will run through one way of estimating the intrinsic value of Hargreaves Services Plc (LON:HSP) by taking the expected future cash flows and discounting them to today's value. This will be done using 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 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.

Check out our latest analysis for Hargreaves Services

The calculation

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

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (£, Millions)	UK£300.1k	UK£15.7m	UK£13.1m	UK£11.6m	UK£10.7m	UK£10.2m	UK£9.82m	UK£9.62m	UK£9.51m	UK£9.46m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Est @ -11.33%	Est @ -7.66%	Est @ -5.09%	Est @ -3.3%	Est @ -2.04%	Est @ -1.16%	Est @ -0.54%
Present Value (£, Millions) Discounted @ 7.3%	UK£0.3	UK£13.6	UK£10.6	UK£8.7	UK£7.5	UK£6.7	UK£6.0	UK£5.5	UK£5.0	UK£4.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£68m

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 7.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = UK£9.5m× (1 + 0.9%) ÷ (7.3%– 0.9%) = UK£149m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£149m÷ ( 1 + 7.3%)¹⁰= UK£74m

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£142m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£4.1, the company appears about fair value at a 5.5% 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.

Important assumptions

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 7.3%, which is based on a levered beta of 1.310. 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:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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 Hargreaves Services, we've compiled three fundamental factors you should further examine:

1. Risks: For example, we've discovered 3 warning signs for Hargreaves Services (1 is a bit unpleasant!) that you should be aware of before investing here.
2. 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.
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. 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.

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.

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