Marks and Spencer Group plc (LON:MKS) Shares Could Be 21% Below Their Intrinsic Value Estimate

Does the February share price for Marks and Spencer Group plc (LON:MKS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. Our analysis will employ 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

Check out our latest analysis for Marks and Spencer Group

Crunching the numbers

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. 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, 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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (£, Millions)	UK£551.1m	UK£343.8m	UK£393.4m	UK£324.0m	UK£321.5m	UK£320.8m	UK£321.1m	UK£322.2m	UK£323.9m	UK£325.9m
Growth Rate Estimate Source	Analyst x13	Analyst x13	Analyst x10	Analyst x3	Analyst x2	Est @ -0.23%	Est @ 0.11%	Est @ 0.35%	Est @ 0.51%	Est @ 0.63%
Present Value (£, Millions) Discounted @ 7.1%	UK£515	UK£300	UK£321	UK£247	UK£228	UK£213	UK£199	UK£187	UK£175	UK£165

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.5b

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 7.1%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = UK£326m× (1 + 0.9%) ÷ (7.1%– 0.9%) = UK£5.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£5.3b÷ ( 1 + 7.1%)¹⁰= UK£2.7b

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£5.2b. 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£2.1, the company appears a touch undervalued at a 21% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important 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. 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 Marks and Spencer 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 7.1%, which is based on a levered beta of 1.261. 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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Marks and Spencer Group, we've put together three relevant factors you should consider:

1. Risks: Every company has them, and we've spotted 1 warning sign for Marks and Spencer Group you should know about.
2. Future Earnings: How does MKS'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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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.