In this article I am going to calculate the intrinsic value of Babcock International Group PLC (LON:BAB) by taking the expected future cash flows and discounting them to today’s value. I will use the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.
Step by step through the calculation
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF (£, Millions)||£312.72||£318.18||£340.29||£369.00||£401.98|
|Source||Analyst x8||Analyst x8||Analyst x7||Analyst x1||Est @ 8.94%|
|Present Value Discounted @ 8.28%||£288.80||£271.38||£268.05||£268.44||£270.07|
Present Value of 5-year Cash Flow (PVCF)= UK£1.37b
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 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = UK£402.0m × (1 + 1.4%) ÷ (8.3% – 1.4%) = UK£5.92b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = UK£5.92b ÷ ( 1 + 8.3%)5 = UK£3.98b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is UK£5.35b. 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 £10.6. Relative to the current share price of £7.23, the stock is quite undervalued at a 31.8% discount to what it is available for right now.
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 Babcock International Group 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 8.3%, which is based on a levered beta of 0.800. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For BAB, I’ve put together three fundamental factors you should look at:
- Financial Health: Does BAB have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does BAB’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: Are there other high quality stocks you could be holding instead of BAB? 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 for every stock on the LON every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.