Stock Analysis

Is Associated British Foods plc (LON:ABF) Trading At A 39% Discount?

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LSE:ABF
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Associated British Foods plc (LON:ABF) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing 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.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Associated British Foods

Crunching the numbers

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.

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) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (£, Millions) UK£504.0m UK£995.9m UK£1.20b UK£1.15b UK£1.26b UK£1.32b UK£1.37b UK£1.41b UK£1.44b UK£1.47b
Growth Rate Estimate Source Analyst x9 Analyst x10 Analyst x8 Analyst x1 Analyst x1 Est @ 4.87% Est @ 3.69% Est @ 2.86% Est @ 2.28% Est @ 1.87%
Present Value (£, Millions) Discounted @ 5.2% UK£479 UK£900 UK£1.0k UK£943 UK£981 UK£978 UK£964 UK£943 UK£917 UK£888

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£9.0b

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 5.2%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£1.5b× (1 + 0.9%) ÷ (5.2%– 0.9%) = UK£35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£35b÷ ( 1 + 5.2%)10= UK£21b

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£30b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£23.3, the company appears quite undervalued at a 39% discount to where the stock price trades currently. 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.

dcf
LSE:ABF Discounted Cash Flow May 25th 2021

The assumptions

Now 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 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 5.2%, 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.

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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. Why is the intrinsic value higher than the current share price? For Associated British Foods, we've put together three essential elements you should look at:

  1. Risks: For example, we've discovered 1 warning sign for Associated British Foods that you should be aware of before investing here.
  2. Future Earnings: How does ABF'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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