A Look At The Fair Value Of Lechwerke AG (FRA:LEC)

editorial-team@simplywallst.com (Simply Wall St)

Thu, Oct 26, 2023, 10:20 PM 6 min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Lechwerke AG (FRA:LEC) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

See our latest analysis for Lechwerke

The Model

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 begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (€, Millions)	€105.8m	€104.6m	€103.9m	€103.5m	€103.3m	€103.3m	€103.4m	€103.6m	€103.8m	€104.1m
Growth Rate Estimate Source	Est @ -1.77%	Est @ -1.14%	Est @ -0.69%	Est @ -0.38%	Est @ -0.16%	Est @ -0.01%	Est @ 0.10%	Est @ 0.18%	Est @ 0.23%	Est @ 0.26%
Present Value (€, Millions) Discounted @ 4.4%	€101	€96.0	€91.4	€87.3	€83.5	€80.0	€76.8	€73.7	€70.8	€68.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €829m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 0.4%. We discount the terminal cash flows to today's value at a cost of equity of 4.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = €104m× (1 + 0.4%) ÷ (4.4%– 0.4%) = €2.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €2.6b÷ ( 1 + 4.4%)¹⁰= €1.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €2.5b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €85.5, the company appears around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf — DB:LEC Discounted Cash Flow October 27th 2023

Important 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 Lechwerke 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 4.4%, which is based on a levered beta of 0.800. 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 Lechwerke

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 Electric Utilities market.

Current share price is above our estimate of fair value.

Opportunity

LEC's financial characteristics indicate limited near-term opportunities for shareholders.

Lack of analyst coverage makes it difficult to determine LEC's earnings prospects.

Threat

Dividends are not covered by earnings.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Instead the best use for 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 rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Lechwerke, there are three further items you should explore:

Risks: Case in point, we've spotted 2 warning signs for Lechwerke you should be aware of, and 1 of them makes us a bit uncomfortable.
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!
Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

PS. Simply Wall St updates its DCF calculation for every German stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.