Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Breedon Group plc (LON:BREE) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for Breedon Group by following the link below.
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 five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow forecast
|Levered FCF (£, Millions)||£71.70||£85.32||£100.68||£117.80||£136.64|
|Source||Analyst x1||Est @ 19%, capped from 27.05%||Est @ 18%, capped from 27.05%||Est @ 17%, capped from 27.05%||Est @ 16%, capped from 27.05%|
|Present Value Discounted @ 8.28%||£66.22||£72.77||£79.31||£85.69||£91.80|
Present Value of 5-year Cash Flow (PVCF)= UK£396m
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 an annual growth rate equal to the 10-year government bond rate of 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = UK£137m × (1 + 1.4%) ÷ (8.3% – 1.4%) = UK£2.0b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = UK£2.0b ÷ ( 1 + 8.3%)5 = UK£1.4b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is UK£1.7b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of £1.04. Relative to the current share price of £0.66, the stock is quite good value at a 37% discount to what it is available for right now.
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 my result, have a go at the calculation yourself and play with the assumptions. Because 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 weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.3%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on 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. What is the reason for the share price to differ from the intrinsic value? For BREE, I’ve compiled three relevant factors you should look at:
- Financial Health: Does BREE have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does BREE’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: Are there other high quality stocks you could be holding instead of BREE? 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 for every stock on the LON every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.