Is There An Opportunity With Entain Plc's (LON:ENT) 45% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Entain fair value estimate is UK£14.91

• Current share price of UK£8.21 suggests Entain is potentially 45% undervalued

• The UK£10.56 analyst price target for ENT is 29% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Entain Plc (LON:ENT) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Entain

Is Entain Fairly Valued?

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£226.2m	UK£387.1m	UK£463.6m	UK£593.0m	UK£677.0m	UK£737.9m	UK£788.0m	UK£829.3m	UK£863.8m	UK£893.2m
Growth Rate Estimate Source	Analyst x3	Analyst x6	Analyst x3	Analyst x1	Analyst x1	Est @ 8.99%	Est @ 6.79%	Est @ 5.24%	Est @ 4.16%	Est @ 3.41%
Present Value (£, Millions) Discounted @ 8.7%	UK£208	UK£328	UK£361	UK£425	UK£447	UK£448	UK£441	UK£427	UK£409	UK£389

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£3.9b

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. 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 5-year average of the 10-year government bond yield (1.6%) 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 8.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£893m× (1 + 1.6%) ÷ (8.7%– 1.6%) = UK£13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£13b÷ ( 1 + 8.7%)¹⁰= UK£5.6b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£9.5b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£8.2, the company appears quite undervalued at a 45% 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.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Entain 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 8.7%, which is based on a levered beta of 1.525. 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.

SWOT Analysis for Entain

Strength

• No major strengths identified for ENT.

Weakness

• Interest payments on debt are not well covered.

• Dividend is low compared to the top 25% of dividend payers in the Hospitality market.

• Shareholders have been diluted in the past year.

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Good value based on P/S ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• Debt is not well covered by operating cash flow.

• Paying a dividend but company is unprofitable.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Entain, we've put together three further aspects you should explore:

1. Risks: You should be aware of the 1 warning sign for Entain we've uncovered before considering an investment in the company.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ENT's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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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This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.