Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Alpha Financial Markets Consulting plc (LON:AFM) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. One way to achieve this is by employing 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.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
|Levered FCF (£, Millions)||UK£17.0m||UK£23.0m||UK£17.0m||UK£13.8m||UK£12.0m||UK£11.0m||UK£10.3m||UK£9.96m||UK£9.74m||UK£9.63m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Analyst x1||Est @ -18.97%||Est @ -12.91%||Est @ -8.67%||Est @ -5.7%||Est @ -3.63%||Est @ -2.17%||Est @ -1.15%|
|Present Value (£, Millions) Discounted @ 7.6%||UK£15.8||UK£19.9||UK£13.6||UK£10.3||UK£8.3||UK£7.1||UK£6.2||UK£5.5||UK£5.0||UK£4.6|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£96m
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 1.2%. We discount the terminal cash flows to today’s value at a cost of equity of 7.6%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£9.6m× (1 + 1.2%) ÷ (7.6%– 1.2%) = UK£153m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£153m÷ ( 1 + 7.6%)10= UK£73m
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£169m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£2.0, 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Alpha Financial Markets Consulting 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 7.6%, which is based on a levered beta of 0.922. 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.
Whilst important, the DCF calculation shouldn’t be the only metric you look at when researching 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?” 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 Alpha Financial Markets Consulting, we’ve put together three additional factors you should look at:
- Risks: Take risks, for example – Alpha Financial Markets Consulting has 1 warning sign we think you should be aware of.
- Future Earnings: How does AFM’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 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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock 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.
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