Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Lena Lighting S.A. (WSE:LEN) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
What's the estimated valuation?
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF (PLN, Millions)||zł10.3m||zł10.3m||zł10.4m||zł10.6m||zł10.8m||zł11.0m||zł11.2m||zł11.5m||zł11.8m||zł12.1m|
|Growth Rate Estimate Source||Est @ -0.62%||Est @ 0.34%||Est @ 1.02%||Est @ 1.49%||Est @ 1.82%||Est @ 2.05%||Est @ 2.21%||Est @ 2.33%||Est @ 2.4%||Est @ 2.46%|
|Present Value (PLN, Millions) Discounted @ 9.3%||zł9.4||zł8.6||zł8.0||zł7.4||zł6.9||zł6.4||zł6.0||zł5.6||zł5.3||zł5.0|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = zł68m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 9.3%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = zł12m× (1 + 2.6%) ÷ (9.3%– 2.6%) = zł184m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= zł184m÷ ( 1 + 9.3%)10= zł76m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is zł144m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of zł5.2, the company appears about fair value at a 9.5% 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.
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 Lena Lighting 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 9.3%, which is based on a levered beta of 1.214. 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.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Lena Lighting, there are three additional factors you should assess:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Lena Lighting (at least 1 which can't be ignored) , and understanding these should be part of your investment process.
- 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!
- Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the WSE 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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