Today we'll do a simple run through of a valuation method used to estimate the attractiveness of FDM Group (Holdings) plc (LON:FDM) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate 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) estimate
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
Levered FCF (£, Millions)
UK£45.2m
UK£51.5m
UK£56.0m
UK£59.5m
UK£62.4m
UK£64.6m
UK£66.4m
UK£68.0m
UK£69.3m
UK£70.4m
Growth Rate Estimate Source
Analyst x1
Analyst x1
Est @ 8.67%
Est @ 6.37%
Est @ 4.75%
Est @ 3.62%
Est @ 2.83%
Est @ 2.28%
Est @ 1.89%
Est @ 1.62%
Present Value (£, Millions) Discounted @ 7.4%
UK£42.1
UK£44.7
UK£45.2
UK£44.8
UK£43.7
UK£42.2
UK£40.4
UK£38.5
UK£36.5
UK£34.5
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = UK£413m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 have used the 5-year average of the 10-year government bond yield (1.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.4%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.1b÷ ( 1 + 7.4%)10= UK£547m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£959m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£7.6, the company appears about fair value at a 13% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
LSE:FDM Discounted Cash Flow January 5th 2023
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 FDM Group (Holdings) 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 7.4%, which is based on a levered beta of 1.005. 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.
SWOT Analysis for FDM Group (Holdings)
Strength
Earnings growth over the past year exceeded the industry.
Currently debt free.
Weakness
Dividend is low compared to the top 25% of dividend payers in the IT market.
Opportunity
Annual revenue is forecast to grow faster than the British market.
Good value based on P/E ratio and estimated fair value.
Threat
Dividends are not covered by earnings and cashflows.
Annual earnings are forecast to grow slower than the British market.
Looking Ahead:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For FDM Group (Holdings), we've put together three fundamental aspects you should consider:
Future Earnings: How does FDM's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
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.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
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