Is there an opportunity with the 40% undervaluation of Watches of Switzerland Group plc (LON: WOSG)?

Today we are going to walk through one way to estimate the intrinsic value of Watches of Switzerland Group plc (LON:WOSG) by estimating the future cash flows of the business and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.

We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

Check out our latest analysis for Watches of Switzerland Group

Calculate numbers

We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for 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 need to discount the sum of these future cash flows to arrive at an estimate of present value:

Estimated free cash flow (FCF) over 10 years

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Leveraged FCF (£, millions) UK£97.6m UK£126.6m UK£142.3m UK£174.8m UK£215.7m UK£243.8m UK£266.8m UK£285.1m UK£299.7m UK£311.4m
Growth rate estimate Source Analyst x5 Analyst x5 Analyst x4 Analyst x2 Analyst x1 East @ 13.03% Is at 9.42% Is at 6.89% Is at 5.12% Is at 3.88%
Present value (in millions of pounds sterling) discounted at 7.2% UK£91.0 UK£110 UK£115 UK£132 UK£152 UK£160 UK£164 UK£163 UK£160 UK£155

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £1.4 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 7.2%.

Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£311m × (1 + 1.0%) ÷ (7.2%– 1.0%) = UK£5.0b

Present value of terminal value (PVTV)= TV / (1 + r)ten= UK£5.0b÷ ( 1 + 7.2%)ten= UK £2.5 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £3.9 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of £9.8 in the UK, the company appears to be pretty good value at a 40% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

LSE: WOSG Discounted Cash Flow November 13, 2022

The hypotheses

We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the 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 consider Watches of Switzerland 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 debt into account. In this calculation, we used 7.2%, which is based on a leveraged beta of 1.067. 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.

Look forward:

Valuation is only one side of the coin in terms of crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. The DCF model is not a perfect stock valuation tool. 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. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is the stock price below intrinsic value? For Watches of Switzerland Group, we have put together three relevant elements that you should evaluate:

  1. Financial health: Does WOSG have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
  2. Future earnings: How does WOSG’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
  3. 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 Swiss Group Watches is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.

See the free analysis

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.

About Myra R.

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