Estimating The Fair Value Of Travis Perkins plc (LON:TPK)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Travis Perkins plc (LON:TPK) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

See our latest analysis for Travis Perkins

Is Travis Perkins fairly valued?

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2020	2021	2022	2023	2024	2025	2026	2027	2028	2029
Levered FCF (£, Millions)	UK£258.9m	UK£294.1m	UK£302.9m	UK£309.1m	UK£314.1m	UK£318.1m	UK£321.5m	UK£324.4m	UK£326.9m	UK£329.2m
Growth Rate Estimate Source	Analyst x8	Analyst x9	Analyst x3	Est @ 2.06%	Est @ 1.6%	Est @ 1.28%	Est @ 1.06%	Est @ 0.9%	Est @ 0.79%	Est @ 0.71%
Present Value (£, Millions) Discounted @ 7.9%	UK£240	UK£253	UK£241	UK£228	UK£215	UK£202	UK£189	UK£177	UK£165	UK£155

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.1b

After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 10-year government bond rate (0.5%) 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 7.9%.

Terminal Value (TV)= FCF₂₀₂₉ × (1 + g) ÷ (r – g) = UK£329m× (1 + 0.5%) ÷ 7.9%– 0.5%) = UK£4.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£4.5b÷ ( 1 + 7.9%)¹⁰= UK£2.1b

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£4.2b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£14.7, the company appears about fair value at a 13% discount to where the stock price trades currently. 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.

LSE:TPK Intrinsic value, March 4th 2020

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Travis Perkins 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 7.9%, which is based on a levered beta of 1.207. 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:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. For Travis Perkins, There are three further factors you should look at:

1. Risks: Be aware that Travis Perkins is showing 2 warning signs in our investment analysis , you should know about...

2. Future Earnings: How does TPK'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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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