Today we are going to review one way to estimate the intrinsic value of NWF Group plc (LON: NWF) by taking expected future cash flows and discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
See our latest analysis for NWF Group
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (£, Million)||United Kingdom £ 7.80 million||United Kingdom £ 8.70 million||United Kingdom £ 8.00m||United Kingdom £ 7.59 million||United Kingdom £ 7.34 million||United Kingdom £ 7.19 million||United Kingdom £ 7.11 million||United Kingdom £ 7.07 million||United Kingdom £ 7.06 million||United Kingdom £ 7.08 million|
|Source of estimated growth rate||Analyst x1||Analyst x1||Analyst x1||Is @ -5.11%||Is @ -3.3%||East @ -2.04%||Is @ -1.15%||East @ -0.53%||East @ -0.09%||East @ 0.21%|
|Present value (£, million) discounted at 9.0%||United Kingdom £ 7.2||United Kingdom £ 7.3||United Kingdom £ 6.2||United Kingdom £ 5.4||UK £ 4.8||United Kingdom £ 4.3||United Kingdom £ 3.9||United Kingdom £ 3.5||United Kingdom £ 3.3||United Kingdom £ 3.0|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = UK £ 48m
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 step. 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 used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 9.0%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK £ 7.1m × (1 + 0.9%) ÷ (9.0% –0.9%) = UK £ 88m
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 88m ÷ (1 + 9.0%)ten= £ 37 million in the UK
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is £ 85million. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current UK £ 1.9 share price, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view NWF Group 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 takes into account debt. In this calculation, we used 9.0%, which is based on a leveraged beta of 1.521. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF is just one of the many factors you need to assess for a business. It is not possible to achieve a rock-solid 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 undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For NWF Group, we have compiled three essential factors that you need to assess:
- Financial health: Does NWF 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 benefits: How does NWF’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every UK stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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