An Intrinsic Calculation For Barratt Developments plc (LON:BDEV) Suggests It's 45% Undervalued

Key Insights

• Barratt Developments' estimated fair value is UK£8.50 based on 2 Stage Free Cash Flow to Equity

• Barratt Developments' UK£4.67 share price signals that it might be 45% undervalued

• Analyst price target for BDEV is UK£5.12 which is 40% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Barratt Developments plc (LON:BDEV) as an investment opportunity 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.

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 Barratt Developments

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£339.5m	UK£407.7m	UK£341.8m	UK£910.0m	UK£847.0m	UK£810.8m	UK£789.3m	UK£777.4m	UK£771.9m	UK£770.7m
Growth Rate Estimate Source	Analyst x5	Analyst x8	Analyst x7	Analyst x1	Analyst x1	Est @ -4.28%	Est @ -2.65%	Est @ -1.51%	Est @ -0.71%	Est @ -0.15%
Present Value (£, Millions) Discounted @ 8.9%	UK£312	UK£344	UK£264	UK£646	UK£552	UK£485	UK£434	UK£392	UK£357	UK£328

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.1b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£771m× (1 + 1.2%) ÷ (8.9%– 1.2%) = UK£10b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£10b÷ ( 1 + 8.9%)¹⁰= UK£4.3b

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£8.4b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£4.7, the company appears quite good value at a 45% 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

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 Barratt Developments 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 8.9%, which is based on a levered beta of 1.117. 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 Barratt Developments

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual earnings are forecast to decline for the next 3 years.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for 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 Barratt Developments, we've put together three pertinent aspects you should assess:

1. Risks: Every company has them, and we've spotted 4 warning signs for Barratt Developments (of which 1 can't be ignored!) you should know about.

2. Future Earnings: How does BDEV'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 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. 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.

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.

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