Stock Analysis

Is Ocado Group plc (LON:OCDO) Worth UK£19.2 Based On Its Intrinsic Value?

LSE:OCDO
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Ocado Group plc (LON:OCDO) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Ocado Group

Step by step through the calculation

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (£, Millions) -UK£477.0m -UK£351.2m -UK£195.2m -UK£119.5m UK£258.1m UK£407.6m UK£574.0m UK£739.6m UK£891.0m UK£1.02b
Growth Rate Estimate Source Analyst x8 Analyst x8 Analyst x6 Analyst x2 Analyst x1 Est @ 57.92% Est @ 40.82% Est @ 28.85% Est @ 20.47% Est @ 14.61%
Present Value (£, Millions) Discounted @ 6.7% -UK£447 -UK£309 -UK£161 -UK£92.4 UK£187 UK£277 UK£365 UK£441 UK£499 UK£536

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£1.3b

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 6.7%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£1.0b× (1 + 0.9%) ÷ (6.7%– 0.9%) = UK£18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£18b÷ ( 1 + 6.7%)10= UK£9.4b

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. 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£19.2, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
LSE:OCDO Discounted Cash Flow June 12th 2021

The 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 Ocado 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 6.7%, which is based on a levered beta of 1.082. 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:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price exceeding the intrinsic value? For Ocado Group, there are three essential factors you should consider:

  1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Ocado Group .
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for OCDO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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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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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