Estimating The Intrinsic Value Of Drax Group plc (LON:DRX)

Key Insights

• The projected fair value for Drax Group is UK£6.82 based on 2 Stage Free Cash Flow to Equity

• With UK£5.80 share price, Drax Group appears to be trading close to its estimated fair value

• Our fair value estimate is 24% lower than Drax Group's analyst price target of UK£9.03

In this article we are going to estimate the intrinsic value of Drax Group plc (LON:DRX) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Drax Group

The Method

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£284.0m	UK£700.5m	UK£637.1m	UK£243.0m	UK£159.5m	UK£117.4m	UK£96.2m	UK£84.4m	UK£77.4m	UK£73.3m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x4	Analyst x2	Analyst x2	Est @ -26.36%	Est @ -18.08%	Est @ -12.29%	Est @ -8.23%	Est @ -5.39%
Present Value (£, Millions) Discounted @ 6.8%	UK£266	UK£614	UK£523	UK£187	UK£115	UK£79.1	UK£60.6	UK£49.8	UK£42.8	UK£37.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.0b

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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£73m× (1 + 1.2%) ÷ (6.8%– 1.2%) = UK£1.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£1.3b÷ ( 1 + 6.8%)¹⁰= UK£688m

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£2.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£5.8, the company appears about fair value at a 15% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Drax 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 6.8%, 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 Drax Group

Strength

• Earnings growth over the past year exceeded the industry.

Weakness

• Interest payments on debt are not well covered.

• Dividend is low compared to the top 25% of dividend payers in the Renewable Energy market.

Opportunity

• Annual earnings are forecast to grow faster than the British market.

• 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 earnings and cashflows.

• Annual revenue is expected to decline over the next 3 years.

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Drax Group, there are three essential aspects you should consider:

1. Risks: Take risks, for example - Drax Group has 3 warning signs (and 2 which make us uncomfortable) we think you should know about.

2. Future Earnings: How does DRX'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.

3. 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here