Today we'll do a simple run through of a valuation method used to estimate the attractiveness of AA plc (LON:AA.) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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 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 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 (£, Millions)||UK£78.0m||UK£81.4m||UK£85.7m||UK£71.5m||UK£74.0m||UK£71.7m||UK£70.2m||UK£69.4m||UK£68.9m||UK£68.6m|
|Growth Rate Estimate Source||Analyst x4||Analyst x3||Analyst x3||Analyst x2||Analyst x1||Est @ -3.11%||Est @ -2.02%||Est @ -1.26%||Est @ -0.72%||Est @ -0.35%|
|Present Value (£, Millions) Discounted @ 13%||UK£69.2||UK£64.2||UK£59.9||UK£44.4||UK£40.8||UK£35.0||UK£30.5||UK£26.7||UK£23.5||UK£20.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£415m
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 13%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£69m× (1 + 0.5%) ÷ 13%– 0.5%) = UK£568m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£568m÷ ( 1 + 13%)10= UK£172m
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£587m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.6, the company appears quite undervalued at a 39% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
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 AA 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 13%, which is based on a levered beta of 2.000. 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.
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. What is the reason for the share price to differ from the intrinsic value? For AA, I've compiled three additional factors you should look at:
- Financial Health: Does AA. 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.
- Future Earnings: How does AA.'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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of AA.? 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 GB stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at email@example.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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