Diploma's estimated fair value is UK£24.10 based on 2 Stage Free Cash Flow to Equity
Current share price of UK£31.26 suggests Diploma is potentially 30% overvalued
Our fair value estimate is 29% lower than Diploma's analyst price target of UK£33.96
How far off is Diploma PLC (LON:DPLM) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
Levered FCF (£, Millions)
Growth Rate Estimate Source
Est @ 6.40%
Est @ 4.90%
Est @ 3.84%
Est @ 3.10%
Est @ 2.59%
Est @ 2.22%
Est @ 1.97%
Est @ 1.79%
Present Value (£, Millions) Discounted @ 7.7%
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£1.4b
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 1.4%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£241m× (1 + 1.4%) ÷ (7.7%– 1.4%) = UK£3.8b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£3.8b÷ ( 1 + 7.7%)10= UK£1.8b
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£3.2b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£31.3, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Diploma 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 7.7%, which is based on a levered beta of 1.077. 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 Diploma
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Dividend is low compared to the top 25% of dividend payers in the Trade Distributors market.
Expensive based on P/E ratio and estimated fair value.
Shareholders have been diluted in the past year.
Annual revenue is forecast to grow faster than the British market.
Annual earnings are forecast to grow slower than the British market.
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. 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 exceeding the intrinsic value? For Diploma, there are three relevant items you should consider:
Risks: We feel that you should assess the 1 warning sign for Diploma we've flagged before making an investment in the company.
Future Earnings: How does DPLM'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.