Today we are going to review a valuation method used to estimate the attractiveness of Kingfisher plc (LON: KGF) as an investment opportunity by projecting its future cash flows and then discounting them to the current value. One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something that interests you.
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We’re going to use a two-stage DCF model, which, as the name suggests, takes into account two growth stages. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year free cash flow (FCF) forecast
|Leverage FCF (£, Million)||United Kingdom £ 616.7 million||United Kingdom £ 376.2 million||United Kingdom £ 521.0 million||United Kingdom £ 518.0 million||United Kingdom £ 617.0 million||United Kingdom £ 621.0 million||United Kingdom £ 625.3 million||United Kingdom £ 630.1 million||United Kingdom £ 635.2 million||UK £ 640.5m|
|Source of growth rate estimate||Analyst x9||Analyst x8||Analyst x9||Analyst x6||Analyst x1||Analyst x1||East @ 0.69%||East @ 0.76%||Is @ 0.81%||Is @ 0.84%|
|Present value (£, million) discounted at 8.6%||United Kingdom £ 568||United Kingdom £ 319||UK £ 407||United Kingdom £ 372||United Kingdom £ 408||United Kingdom £ 378||United Kingdom £ 351||United Kingdom £ 325||United Kingdom £ 302||United Kingdom £ 281|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 3.7 billion in the UK
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. 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 used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 8.6%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK £ 640m × (1 + 0.9%) ÷ (8.6% –0.9%) = UK £ 8.4b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 8.4b ÷ (1 + 8.6%)ten= £ 3.7 billion in the UK
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is £ 7.4 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 3.5, the company appears to be roughly at fair value with a 1.4% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Kingfisher 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 takes into account debt. In this calculation, we used 8.6%, which is based on a leveraged beta of 1.447. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
While valuing a business is important, it’s just one of the many factors you need to assess for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Kingfisher, there are three fundamental factors you should research further:
- Risks: We think you should evaluate the 1 warning sign for Kingfisher we reported before making an investment in the business.
- Future benefits: How does KGF’s growth rate compare to that of its peers and the wider market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every share on the LSE. If you want to find the calculation for other actions, do a search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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