Calculating The Intrinsic Value Of National Grid plc (LON:NG.)
Key Insights
Using the Dividend Discount Model, National Grid fair value estimate is UK£12.73
Current share price of UK£10.44 suggests National Grid is potentially trading close to its fair value
Our fair value estimate is 12% higher than National Grid's analyst price target of UK£11.39
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of National Grid plc (LON:NG.) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 National Grid
What's The Estimated Valuation?
We have to calculate the value of National Grid slightly differently to other stocks because it is a integrated utilities company. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We then discount this figure to today's value at a cost of equity of 6.2%. Relative to the current share price of UK£10.4, the company appears about fair value at a 18% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)
= UK£0.6 / (6.2% – 1.5%)
= UK£12.7
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 National Grid 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 6.2%, 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 National Grid
Strength
No major strengths identified for NG..
Weakness
Earnings declined over the past year.
Interest payments on debt are not well covered.
Dividend is low compared to the top 25% of dividend payers in the Integrated Utilities market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Current share price is below our estimate of fair value.
Threat
Debt is not well covered by operating cash flow.
Dividends are not covered by cash flow.
Annual earnings are forecast to grow slower than the British market.
Looking Ahead:
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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For National Grid, there are three fundamental aspects you should consider:
Risks: Every company has them, and we've spotted 2 warning signs for National Grid (of which 1 is potentially serious!) you should know about.
Future Earnings: How does NG.'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.
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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.
