Stock Analysis

NEXT plc (LON:NXT) Shares Could Be 44% Below Their Intrinsic Value Estimate

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LSE:NXT
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Today we will run through one way of estimating the intrinsic value of NEXT plc (LON:NXT) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for NEXT

The model

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) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (£, Millions) UK£442.1m UK£520.3m UK£623.0m UK£641.8m UK£655.8m UK£667.5m UK£677.6m UK£686.6m UK£694.8m UK£702.4m
Growth Rate Estimate Source Analyst x9 Analyst x10 Analyst x10 Analyst x7 Est @ 2.18% Est @ 1.79% Est @ 1.52% Est @ 1.33% Est @ 1.19% Est @ 1.1%
Present Value (£, Millions) Discounted @ 5.6% UK£418 UK£466 UK£528 UK£515 UK£498 UK£480 UK£462 UK£443 UK£424 UK£406

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.6b

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 5.6%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£702m× (1 + 0.9%) ÷ (5.6%– 0.9%) = UK£15b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£15b÷ ( 1 + 5.6%)10= UK£8.6b

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£13b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£58.4, the company appears quite good value at a 44% 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 April 8th 2022

The assumptions

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 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 0.983. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For NEXT, we've compiled three essential items you should consider:

  1. Risks: You should be aware of the 2 warning signs for NEXT we've uncovered before considering an investment in the company.
  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 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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