In this article we are going to estimate the intrinsic value of Capita plc (LON:CPI) by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. 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.
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. To begin with, we have to get estimates of the next ten years of cash flows. 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
|Levered FCF (£, Millions)||UK£3.55m||UK£25.0m||UK£39.6m||UK£55.8m||UK£72.0m||UK£86.9m||UK£99.6m||UK£110.1m||UK£118.6m||UK£125.3m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 58.28%||Est @ 41.07%||Est @ 29.02%||Est @ 20.59%||Est @ 14.69%||Est @ 10.56%||Est @ 7.67%||Est @ 5.64%|
|Present Value (£, Millions) Discounted @ 12%||UK£3.2||UK£20.1||UK£28.5||UK£36.1||UK£41.7||UK£45.1||UK£46.4||UK£46.0||UK£44.4||UK£42.0|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£353m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 12%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£125m× (1 + 0.9%) ÷ (12%– 0.9%) = UK£1.2b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.2b÷ ( 1 + 12%)10= UK£399m
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£752m. 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£0.5, the company appears around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Capita 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 12%, which is based on a levered beta of 2.000. 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.
Whilst important, the DCF calculation 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. 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. For Capita, there are three essential items you should further examine:
- Risks: For instance, we've identified 4 warning signs for Capita (3 are concerning) you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CPI's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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.
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