Today we will run through one way of estimating the intrinsic value of 4imprint Group plc (LON:FOUR) 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. 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, 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
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
Levered FCF ($, Millions)
US$26.9m
US$38.7m
US$47.9m
US$49.3m
US$50.4m
US$51.4m
US$52.2m
US$53.1m
US$53.8m
US$54.6m
Growth Rate Estimate Source
Analyst x3
Analyst x3
Analyst x1
Analyst x1
Est @ 2.22%
Est @ 1.92%
Est @ 1.71%
Est @ 1.56%
Est @ 1.46%
Est @ 1.39%
Present Value ($, Millions) Discounted @ 7.0%
US$25.2
US$33.8
US$39.1
US$37.7
US$36.0
US$34.3
US$32.6
US$31.0
US$29.4
US$27.8
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$326m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$962m÷ ( 1 + 7.0%)10= US$491m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$817m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£24.7, the company appears around fair value at the time of writing. 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.
LSE:FOUR Discounted Cash Flow August 12th 2020
Important assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 4imprint 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 accounts for debt. In this calculation we've used 7.0%, which is based on a levered beta of 0.829. 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.
Moving On:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For 4imprint Group, we've compiled three additional aspects you should look at:
Risks: You should be aware of the 2 warning signs for 4imprint Group (1 is a bit unpleasant!) we've uncovered before considering an investment in the company.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for FOUR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks just search here.
This article by Simply Wall St is general in nature. 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.
