In this article we are going to estimate the intrinsic value of Breedon Group plc (LON:BREE) 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.
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. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
|Levered FCF (£, Millions)||UK£86.6m||UK£104.2m||UK£102.6m||UK£101.8m||UK£101.6m||UK£101.8m||UK£102.2m||UK£102.8m||UK£103.5m||UK£104.3m|
|Growth Rate Estimate Source||Analyst x5||Analyst x4||Est @ -1.49%||Est @ -0.74%||Est @ -0.22%||Est @ 0.15%||Est @ 0.4%||Est @ 0.58%||Est @ 0.71%||Est @ 0.79%|
|Present Value (£, Millions) Discounted @ 5.6%||UK£82.1||UK£93.5||UK£87.2||UK£82.0||UK£77.5||UK£73.5||UK£69.9||UK£66.6||UK£63.6||UK£60.7|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£756m
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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 5.6%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£104m× (1 + 1.0%) ÷ (5.6%– 1.0%) = UK£2.3b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£2.3b÷ ( 1 + 5.6%)10= UK£1.3b
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£2.1b. 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£0.9, the company appears a touch undervalued at a 29% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Breedon 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 5.6%, which is based on a levered beta of 0.873. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Breedon Group, we've put together three important elements you should consider:
- Risks: For example, we've discovered 1 warning sign for Breedon Group that you should be aware of before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BREE's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. 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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