Stock Analysis

Calculating The Fair Value Of Associated British Foods plc (LON:ABF)

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LSE:ABF
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How far off is Associated British Foods plc (LON:ABF) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.

View our latest analysis for Associated British Foods

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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (£, Millions) UK£657.7m UK£1.07b UK£1.25b UK£1.16b UK£1.11b UK£1.07b UK£1.05b UK£1.04b UK£1.04b UK£1.04b
Growth Rate Estimate Source Analyst x9 Analyst x8 Analyst x6 Analyst x1 Est @ -4.66% Est @ -2.96% Est @ -1.77% Est @ -0.94% Est @ -0.36% Est @ 0.05%
Present Value (£, Millions) Discounted @ 5.8% UK£622 UK£956 UK£1.1k UK£927 UK£836 UK£767 UK£712 UK£667 UK£628 UK£594

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£7.8b

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 (1.0%) 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 5.8%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£1.0b× (1 + 1.0%) ÷ (5.8%– 1.0%) = UK£22b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£22b÷ ( 1 + 5.8%)10= UK£13b

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£20b. 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£23.7, the company appears about fair value at a 8.0% 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.

dcf
LSE:ABF Discounted Cash Flow February 22nd 2021

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. 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 Associated British Foods 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 5.8%, which is based on a levered beta of 0.800. 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.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess 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 Associated British Foods, we've put together three pertinent items you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Associated British Foods , and understanding them should be part of your investment process.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ABF's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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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