Does the July share price for Avon Rubber p.l.c. (LON:AVON) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
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.
Is Avon Rubber fairly valued?
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. 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) estimate
|Levered FCF (£, Millions)||UK£30.3m||UK£37.6m||UK£42.9m||UK£47.3m||UK£50.9m||UK£53.8m||UK£56.1m||UK£58.0m||UK£59.6m||UK£61.0m|
|Growth Rate Estimate Source||Analyst x4||Analyst x4||Est @ 14.19%||Est @ 10.3%||Est @ 7.58%||Est @ 5.67%||Est @ 4.33%||Est @ 3.4%||Est @ 2.75%||Est @ 2.29%|
|Present Value (£, Millions) Discounted @ 7.2%||UK£28.2||UK£32.7||UK£34.8||UK£35.8||UK£36.0||UK£35.5||UK£34.5||UK£33.3||UK£31.9||UK£30.5|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£333m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (1.2%) 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 7.2%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£61m× (1 + 1.2%) ÷ (7.2%– 1.2%) = UK£1.0b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.0b÷ ( 1 + 7.2%)10= UK£518m
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£851m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£36.9, the company appears reasonably expensive 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Avon Rubber 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 7.2%, which is based on a levered beta of 0.861. 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 ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For Avon Rubber, there are three further factors you should further research:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Avon Rubber (at least 2 which are significant) , and understanding them should be part of your investment process.
- Future Earnings: How does AVON'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. 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.