Does the December share price for Hargreaves Services Plc (LON:HSP) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.
Step By Step Through The Calculation
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. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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£7.57m||UK£20.3m||UK£16.9m||UK£15.0m||UK£13.8m||UK£13.1m||UK£12.7m||UK£12.4m||UK£12.3m||UK£12.2m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ -16.77%||Est @ -11.44%||Est @ -7.71%||Est @ -5.1%||Est @ -3.27%||Est @ -2%||Est @ -1.1%||Est @ -0.47%|
|Present Value (£, Millions) Discounted @ 9.2%||UK£6.9||UK£17.0||UK£13.0||UK£10.5||UK£8.9||UK£7.7||UK£6.9||UK£6.2||UK£5.6||UK£5.1|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£87m
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. 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 (1.0%) 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 9.2%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£12m× (1 + 1.0%) ÷ (9.2%– 1.0%) = UK£151m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£151m÷ ( 1 + 9.2%)10= UK£63m
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£150m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£3.8, the company appears about fair value at a 18% 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.
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 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 9.2%, which is based on a levered beta of 1.286. 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 Hargreaves Services
- Earnings growth over the past year exceeded its 5-year average.
- Currently debt free.
- Earnings growth over the past year underperformed the Oil and Gas industry.
- Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.
- Annual revenue is forecast to grow faster than the British market.
- Current share price is below our estimate of fair value.
- Paying a dividend but company has no free cash flows.
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. 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Hargreaves Services, we've put together three further items you should further research:
- Risks: You should be aware of the 3 warning signs for Hargreaves Services (1 is significant!) we've uncovered before considering an investment in the company.
- 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. 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. 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.
Hargreaves Services plc, together with its subsidiaries, provides materials handling, mechanical and electrical contracting, logistics, and major earthmoving services for energy, environmental, infrastructure, and industrial sectors.
Flawless balance sheet with proven track record and pays a dividend.