Today we will review a valuation method used to estimate the attractiveness of Encavis AG (ETR: ECV) as an investment opportunity by estimating the company’s future cash flows and discounting them to their current value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something that interests you.
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Crunch the numbers
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.
In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (€, Millions)||165.1 M €||€ 130.7m||137.8 million euros||€ 120.3m||€ 143.9m||€ 145.6m||146.8 M €||147.6 M €||148.2 M €||148.6 M €|
|Source of growth rate estimate||Analyst x5||Analyst x4||Analyst x4||Analyst x2||Analyst x2||Est @ 1.17%||Is @ 0.82%||Is @ 0.58%||East @ 0.41%||Is 0.29%|
|Present value (€, Millions) discounted @ 3.8%||€ 159||€ 121||€ 123||104 €||€ 119||€ 116||€ 113||€ 110||€ 106||€ 103|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = € 1.2bn
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. 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 0.01%. We discount the terminal cash flows to their present value at a cost of equity of 3.8%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = € 149m × (1 + 0.01%) ÷ (3.8% – 0.01%) = € 3.9bn
Present value of terminal value (PVTV)= TV / (1 + r)ten= € 3.9bn ÷ (1 + 3.8%)ten= € 2.7bn
The total value is the sum of the cash flows of the next ten years plus the present terminal value, which gives the Total Equity Value, which in this case is 3.9 billion euros. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of € 15.6, the company looks fairly good value with a 45% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is 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 complete picture of a company’s potential performance. Because we view Encavis 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 3.8%, which is based on a leverage beta of 0.800. 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 shouldn’t be the only metric you look at when looking for a business. The DCF model is not a perfect equity valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Can we understand why the company trades at a discount to its intrinsic value? For Encavis, there are three essential aspects to explore:
- Risks: To this end, you should inquire about the 3 warning signs we spotted with Encavis (including 1 which is disturbing).
- Future benefits: How does ECV’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 high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every share on the XTRA. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. 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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