The calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with we need to estimate the next five years of cash flows. Where possible I use analyst estimates, but when these aren't available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow predict
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF (£, Millions) | £125.00 | £183.00 | £190.00 | £194.82 | £199.76 |
| Source | Analyst x1 | Analyst x1 | Analyst x1 | Extrapolated @ (2.54%) | Extrapolated @ (2.54%) |
| Present Value Discounted @ 8.3% | £115.42 | £156.03 | £149.59 | £141.63 | £134.09 |
Present Value of 5-year Cash Flow (PVCF)= £697
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (1.5%). In the same way as with the 5-year 'growth' period, we discount this to today's value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = £200 × (1 + 1.5%) ÷ (8.3% – 1.5%) = £2,978
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = £2,978 / ( 1 + 8.3%)5 = £1,999
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is £2,696. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of £6.43, which, compared to the current share price of £6.19, we see that Pennon Group is about right, perhaps slightly undervalued at a 3.70% discount to what it is available for right now.
The assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Pennon Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I've used 8.3%, which is based on a levered beta of 0.8. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For PNN, I've compiled three important factors you should further research:
- 1. Financial Health: Does PNN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 2. Future Earnings: How does PNN'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.
- 2. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of PNN? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every GB stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.
About LSE:PNN
Pennon Group
Provides water and wastewater services for household and non-household customers in the United Kingdom.
Reasonable growth potential low.
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