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In this article I am going to calculate the intrinsic value of Telecom Italia S.p.A. (BIT:TIT) by estimating the company’s future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for Telecom Italia by following the link below.

See our latest analysis for Telecom Italia

The calculation

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 five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.

5-year cash flow forecast

Present Value of 5-year Cash Flow (PVCF)= €5.4b

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 an annual growth rate equal to the 10-year government bond rate of 1.8%. We discount this to today’s value at a cost of equity of 13.5%.

Terminal Value (TV) = FCF₂₀₂₃ × (1 + g) ÷ (r – g) = €1.5b × (1 + 1.8%) ÷ (13.5% – 1.8%) = €13b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = €13b ÷ ( 1 + 13.5%)⁵ = €7.0b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is €12b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of €0.59. Compared to the current share price of €0.48, the stock is about right, perhaps slightly undervalued at a 18% discount to what it is available for right now.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Telecom Italia as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 13.5%, which is based on a levered beta of 1.424. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.