Are Investors Undervaluing WPP plc (LON:WPP) By 50%?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of WPP plc (LON:WPP) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for WPP

Is WPP 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 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 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£1.17b	UK£1.25b	UK£1.39b	UK£1.45b	UK£1.49b	UK£1.53b	UK£1.56b	UK£1.58b	UK£1.60b	UK£1.63b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x1	Analyst x1	Est @ 2.93%	Est @ 2.35%	Est @ 1.94%	Est @ 1.66%	Est @ 1.46%	Est @ 1.32%
Present Value (£, Millions) Discounted @ 8.4%	UK£1.1k	UK£1.1k	UK£1.1k	UK£1.0k	UK£994	UK£939	UK£882	UK£827	UK£774	UK£723

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£9.4b

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. 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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£1.6b× (1 + 1.0%) ÷ (8.4%– 1.0%) = UK£22b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£22b÷ ( 1 + 8.4%)¹⁰= UK£9.8b

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£19b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£9.0, the company appears quite undervalued at a 50% 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.

dcf

The 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. 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 WPP 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 8.4%, which is based on a levered beta of 1.088. 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 WPP

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is well covered by earnings.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Media industry.

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

Opportunity

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

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

Threat

• Debt is not well covered by operating cash flow.

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

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For WPP, we've compiled three additional elements you should explore:

1. Risks: Every company has them, and we've spotted 2 warning signs for WPP (of which 1 is a bit unpleasant!) you should know about.

2. Future Earnings: How does WPP'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.

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