Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Revolution Beauty Group plc (LON:REVB) as an investment opportunity by taking the expected future cash flows and discounting them to their present 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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 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) estimate
|Levered FCF (£, Millions)||UK£3.00m||UK£10.5m||UK£14.0m||UK£16.6m||UK£18.8m||UK£20.6m||UK£22.1m||UK£23.2m||UK£24.1m||UK£24.8m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Est @ 18.63%||Est @ 13.31%||Est @ 9.59%||Est @ 6.98%||Est @ 5.16%||Est @ 3.88%||Est @ 2.99%|
|Present Value (£, Millions) Discounted @ 5.8%||UK£2.8||UK£9.4||UK£11.8||UK£13.3||UK£14.2||UK£14.7||UK£14.9||UK£14.8||UK£14.6||UK£14.2|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£124m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 5.8%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£25m× (1 + 0.9%) ÷ (5.8%– 0.9%) = UK£516m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£516m÷ ( 1 + 5.8%)10= UK£295m
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£419m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.3, the company appears about fair value at a 5.4% 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.
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 Revolution Beauty Group 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 0.993. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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 Revolution Beauty Group, there are three fundamental factors you should further research:
- Risks: As an example, we've found 3 warning signs for Revolution Beauty Group (2 don't sit too well with us!) that you need to consider before investing here.
- Future Earnings: How does REVB'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.
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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