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Luceco plc (LON:LUCE) Shares Could Be 31% Below Their Intrinsic Value Estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Luceco plc (LON:LUCE) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 Luceco

The method

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.

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) estimate

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (£, Millions)

UK£32.1m

UK£37.4m

UK£41.9m

UK£45.4m

UK£48.3m

UK£50.5m

UK£52.3m

UK£53.8m

UK£54.9m

UK£55.9m

Growth Rate Estimate Source

Analyst x2

Est @ 16.48%

Est @ 11.81%

Est @ 8.54%

Est @ 6.26%

Est @ 4.66%

Est @ 3.53%

Est @ 2.75%

Est @ 2.2%

Est @ 1.82%

Present Value (£, Millions) Discounted @ 7.1%

UK£30.0

UK£32.6

UK£34.1

UK£34.5

UK£34.3

UK£33.5

UK£32.4

UK£31.1

UK£29.6

UK£28.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£320m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 0.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£56m× (1 + 0.9%) ÷ (7.1%– 0.9%) = UK£914m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£914m÷ ( 1 + 7.1%)10= UK£461m

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£781m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£3.5, the company appears quite good value at a 31% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
dcf

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 Luceco 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 7.1%, which is based on a levered beta of 1.163. 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.

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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Luceco, we've compiled three important aspects you should assess:

  1. Risks: For example, we've discovered 3 warning signs for Luceco (1 shouldn't be ignored!) that you should be aware of before investing here.

  2. Future Earnings: How does LUCE'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.

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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