Stock Analysis

Estimating The Fair Value Of NEXT plc (LON:NXT)

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LSE:NXT
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Does the December share price for NEXT plc (LON:NXT) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. This will be done using 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.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 NEXT

Step by step through the calculation

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. 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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (£, Millions) UK£509.5m UK£624.8m UK£651.5m UK£612.3m UK£588.2m UK£573.5m UK£565.1m UK£560.8m UK£559.3m UK£559.8m
Growth Rate Estimate Source Analyst x8 Analyst x10 Analyst x8 Est @ -6.02% Est @ -3.94% Est @ -2.49% Est @ -1.47% Est @ -0.76% Est @ -0.26% Est @ 0.09%
Present Value (£, Millions) Discounted @ 5.6% UK£483 UK£561 UK£554 UK£493 UK£449 UK£414 UK£387 UK£364 UK£344 UK£326

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.4b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 5.6%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£560m× (1 + 0.9%) ÷ (5.6%– 0.9%) = UK£12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£12b÷ ( 1 + 5.6%)10= UK£7.1b

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£11b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£77.4, the company appears about fair value at a 13% 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.

dcf
LSE:NXT Discounted Cash Flow December 16th 2021

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 NEXT 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 0.953. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For NEXT, we've compiled three important elements you should explore:

  1. Risks: Take risks, for example - NEXT has 1 warning sign we think you should be aware of.
  2. Future Earnings: How does NXT'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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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