An Intrinsic Calculation For J Sainsbury plc (LON:SBRY) Suggests It's 43% Undervalued

Key Insights

• The projected fair value for J Sainsbury is UK£4.49 based on 2 Stage Free Cash Flow to Equity

• J Sainsbury's UK£2.56 share price signals that it might be 43% undervalued

• Our fair value estimate is 66% higher than J Sainsbury's analyst price target of UK£2.70

Does the October share price for J Sainsbury plc (LON:SBRY) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for J Sainsbury

Is J Sainsbury Fairly Valued?

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.

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£429.0m	UK£447.5m	UK£574.5m	UK£710.0m	UK£742.0m	UK£766.1m	UK£786.7m	UK£804.7m	UK£821.0m	UK£836.0m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Est @ 3.25%	Est @ 2.69%	Est @ 2.29%	Est @ 2.02%	Est @ 1.83%
Present Value (£, Millions) Discounted @ 7.9%	UK£397	UK£384	UK£457	UK£523	UK£506	UK£484	UK£461	UK£437	UK£413	UK£389

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.5b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.4%) 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 7.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£836m× (1 + 1.4%) ÷ (7.9%– 1.4%) = UK£13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£13b÷ ( 1 + 7.9%)¹⁰= UK£6.0b

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£10b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£2.6, the company appears quite undervalued at a 43% 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

Important Assumptions

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. 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 J Sainsbury 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 7.9%, which is based on a levered beta of 1.111. 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 J Sainsbury

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

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

Opportunity

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

• Trading below our estimate of fair value by more than 20%.

Threat

• Dividends are not covered by earnings.

• Annual revenue is forecast to grow slower than the British market.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For J Sainsbury, we've put together three important factors you should explore:

1. Risks: Take risks, for example - J Sainsbury has 3 warning signs we think you should be aware of.

2. Future Earnings: How does SBRY'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. 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.