British American Tobacco p.l.c.'s (LON:BATS) Intrinsic Value Is Potentially 92% Above Its Share Price

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of British American Tobacco p.l.c. (LON:BATS) 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for British American Tobacco

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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (£, Millions)	UK£7.71b	UK£8.29b	UK£8.63b	UK£8.63b	UK£6.92b	UK£6.70b	UK£6.57b	UK£6.50b	UK£6.47b	UK£6.47b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x8	Analyst x2	Analyst x1	Est @ -3.24%	Est @ -1.97%	Est @ -1.08%	Est @ -0.45%	Est @ -0.02%
Present Value (£, Millions) Discounted @ 6.4%	UK£7.2k	UK£7.3k	UK£7.2k	UK£6.7k	UK£5.1k	UK£4.6k	UK£4.3k	UK£4.0k	UK£3.7k	UK£3.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£54b

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 a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK£6.5b× (1 + 1.0%) ÷ (6.4%– 1.0%) = UK£121b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£121b÷ ( 1 + 6.4%)¹⁰= UK£65b

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£119b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£27.1, the company appears quite undervalued at a 48% discount to where the stock price trades currently. 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.

dcf

Important assumptions

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 British American Tobacco 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 6.4%, which is based on a levered beta of 0.905. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price sitting below the intrinsic value? For British American Tobacco, we've put together three fundamental factors you should consider:

1. Risks: Take risks, for example - British American Tobacco has 2 warning signs we think you should be aware of.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BATS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. 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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