Stock Analysis

Is There An Opportunity With easyJet plc's (LON:EZJ) 29% Undervaluation?

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LSE:EZJ
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of easyJet plc (LON:EZJ) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 easyJet

What's the estimated valuation?

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. 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 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£74.4m UK£211.7m UK£215.7m UK£305.5m UK£374.2m UK£434.1m UK£483.9m UK£524.1m UK£556.0m UK£581.1m
Growth Rate Estimate Source Analyst x8 Analyst x8 Analyst x3 Analyst x2 Est @ 22.48% Est @ 16.01% Est @ 11.48% Est @ 8.3% Est @ 6.08% Est @ 4.53%
Present Value (£, Millions) Discounted @ 7.4% UK£69.3 UK£184 UK£174 UK£230 UK£262 UK£284 UK£294 UK£297 UK£293 UK£286

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.4b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 7.4%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£581m× (1 + 0.9%) ÷ (7.4%– 0.9%) = UK£9.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£9.1b÷ ( 1 + 7.4%)10= UK£4.5b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£6.8b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£6.4, the company appears a touch undervalued at a 29% 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:EZJ Discounted Cash Flow October 18th 2021

The assumptions

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 easyJet 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 7.4%, which is based on a levered beta of 1.321. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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. What is the reason for the share price sitting below the intrinsic value? For easyJet, there are three further aspects you should consider:

  1. Risks: Every company has them, and we've spotted 3 warning signs for easyJet (of which 2 are a bit unpleasant!) you should know about.
  2. Future Earnings: How does EZJ'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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