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Are Investors Undervaluing ITV plc (LON:ITV) By 33%?

Simply Wall St

In this article we are going to estimate the intrinsic value of ITV plc (LON:ITV) by estimating the company's future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for ITV

Step by step through the calculation

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (£, Millions) UK£459.2m UK£473.9m UK£485.3m UK£495.2m UK£504.2m UK£512.4m UK£520.1m UK£527.5m UK£534.7m UK£541.8m
Growth Rate Estimate Source Analyst x7 Analyst x6 Est @ 2.4% Est @ 2.05% Est @ 1.8% Est @ 1.63% Est @ 1.51% Est @ 1.42% Est @ 1.37% Est @ 1.32%
Present Value (£, Millions) Discounted @ 7.4% UK£427 UK£410 UK£391 UK£372 UK£352 UK£333 UK£315 UK£297 UK£280 UK£264

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£3.4b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 10-year government bond rate (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 7.4%.

Terminal Value (TV)= FCF2019 × (1 + g) ÷ (r – g) = UK£542m× (1 + 1.2%) ÷ 7.4%– 1.2%) = UK£8.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£8.8b÷ ( 1 + 7.4%)10= UK£4.3b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£7.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.3, the company appears quite undervalued at a 33% 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.

LSE:ITV Intrinsic value, October 14th 2019

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 ITV 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 7.4%, 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.

Next Steps:

Although the valuation of a company is important, 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. What is the reason for the share price to differ from the intrinsic value? For ITV, I've put together three further aspects you should further research:

  1. Financial Health: Does ITV have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does ITV'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: Are there other high quality stocks you could be holding instead of ITV? 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.