Today we’re going to take a simple walkthrough of a valuation method used to estimate the attractiveness of Diageo plc (LON:DGE) as an investment opportunity by projecting its future cash flows and then discounting to the current value. On this occasion, we will use the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it may seem quite complex.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
Check opportunities and risks within the UK beverage industry.
Is Diageo valued enough?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (£, millions)||UK£3.48 billion||UK£3.68 billion||UK£4.20 billion||UK£4.19 billion||UK£4.20 billion||UK£4.22 billion||UK£4.24 billion||UK£4.27 billion||UK£4.31 billion||UK£4.34 billion|
|Growth rate estimate Source||Analyst x8||Analyst x8||Analyst x7||Analyst x1||Is at 0.18%||Is at 0.42%||Is at 0.59%||Is at 0.71%||Is at 0.8%||Is 0.85%|
|Present value (in millions of pounds sterling) discounted at 5.3%||UK£3.3k||UK£3.3k||UK£3.6k||UK£3.4k||UK£3.3k||UK£3.1k||UK£3.0k||UK£2.8k||UK£2.7k||UK£2.6k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £31 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the 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 terminal cash flows to present value at a cost of equity of 5.3%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = £4.3 billion × (1 + 1.0%) ÷ (5.3%–1.0%) = £103 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £103 billion ÷ (1 + 5.3%)ten= UK £61 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £93 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current UK share price of £36.1, the company appears to be about fair value at an 11% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.
We emphasize that 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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Diageo 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 factors in debt. In this calculation, we used 5.3%, which is based on a leveraged beta of 0.800. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
While a business valuation is important, it shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of 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 have a significant impact on the valuation. For Diageo, we’ve put together three important things you should explore:
- Risks: For this purpose, you must know the 1 warning sign we spotted with Diageo.
- Future earnings: How does DGE’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs an updated cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks, search here.
Valuation is complex, but we help make it simple.
Find out if Diageo is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.