Is Chemring Group PLC (LON:CHG) Trading At A 34% Discount?
In this article we are going to estimate the intrinsic value of Chemring Group PLC (LON:CHG) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 Chemring Group
The calculation
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 start off with, we need to estimate 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Levered FCF (£, Millions) | UK£28.2m | UK£41.4m | UK£48.7m | UK£53.5m | UK£57.4m | UK£60.4m | UK£62.9m | UK£64.8m | UK£66.3m | UK£67.6m |
Growth Rate Estimate Source | Analyst x5 | Analyst x5 | Analyst x4 | Est @ 9.92% | Est @ 7.21% | Est @ 5.32% | Est @ 3.99% | Est @ 3.06% | Est @ 2.42% | Est @ 1.96% |
Present Value (£, Millions) Discounted @ 5.5% | UK£26.7 | UK£37.2 | UK£41.5 | UK£43.3 | UK£44.0 | UK£43.9 | UK£43.3 | UK£42.3 | UK£41.1 | UK£39.7 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£402m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 0.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.5%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£68m× (1 + 0.9%) ÷ (5.5%– 0.9%) = UK£1.5b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.5b÷ ( 1 + 5.5%)10= UK£877m
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£1.3b. 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£3.0, the company appears quite undervalued at a 34% 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.
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 Chemring Group 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 5.5%, which is based on a levered beta of 0.935. 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 shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Chemring Group, we've compiled three relevant elements you should look at:
Risks: For example, we've discovered 1 warning sign for Chemring Group that you should be aware of before investing here.
Future Earnings: How does CHG'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
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.
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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.
