Stock Analysis

An Intrinsic Calculation For SSE plc (LON:SSE) Suggests It's 48% Undervalued

  •  Updated
LSE:SSE
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In this article we are going to estimate the intrinsic value of SSE plc (LON:SSE) by taking the expected future cash flows and discounting them to their present value. This will be done using 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 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 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 SSE

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. 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) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (£, Millions) UK£697.5m UK£36.3m UK£41.7m -UK£3.62m UK£425.3m UK£690.0m UK£992.7m UK£1.30b UK£1.59b UK£1.84b
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x3 Analyst x4 Analyst x3 Est @ 62.23% Est @ 43.86% Est @ 31.01% Est @ 22% Est @ 15.7%
Present Value (£, Millions) Discounted @ 5.8% UK£659 UK£32.4 UK£35.2 -UK£2.9 UK£321 UK£493 UK£670 UK£830 UK£958 UK£1.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£5.0b

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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 5.8%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£1.8b× (1 + 1.0%) ÷ (5.8%– 1.0%) = UK£39b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£39b÷ ( 1 + 5.8%)10= UK£22b

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£27b. 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£13.8, the company appears quite undervalued at a 48% 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:SSE Discounted Cash Flow March 15th 2021

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 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 SSE 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 5.8%, which is based on a levered beta of 0.800. 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 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. 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. Why is the intrinsic value higher than the current share price? For SSE, we've compiled three additional elements you should further examine:

  1. Risks: For example, we've discovered 3 warning signs for SSE (2 make us uncomfortable!) that you should be aware of before investing here.
  2. Future Earnings: How does SSE'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

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