Today we will run through one way of estimating the intrinsic value of Avon Protection plc (LON:AVON) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF ($, Millions)
US$29.0m
US$17.4m
US$32.9m
US$34.8m
US$36.4m
US$37.8m
US$39.0m
US$40.1m
US$41.0m
US$42.0m
Growth Rate Estimate Source
Analyst x3
Analyst x3
Analyst x3
Est @ 5.88%
Est @ 4.64%
Est @ 3.78%
Est @ 3.18%
Est @ 2.76%
Est @ 2.46%
Est @ 2.25%
Present Value ($, Millions) Discounted @ 6.6%
US$27.2
US$15.3
US$27.1
US$26.9
US$26.4
US$25.7
US$24.9
US$24.0
US$23.0
US$22.1
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$243m
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 (1.8%) 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 6.6%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$880m÷ ( 1 + 6.6%)10= US$463m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$706m. 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£13.6, the company appears a touch undervalued at a 26% 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:AVON Discounted Cash Flow May 28th 2024
Important Assumptions
Now 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 Avon Protection 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 6.6%, which is based on a levered beta of 0.886. 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 Avon Protection
Strength
Debt is well covered by cash flow.
Weakness
Interest payments on debt are not well covered.
Dividend is low compared to the top 25% of dividend payers in the Aerospace & Defense market.
Opportunity
Expected to breakeven next year.
Has sufficient cash runway for more than 3 years based on current free cash flows.
Trading below our estimate of fair value by more than 20%.
Threat
Paying a dividend but company is unprofitable.
Moving On:
Whilst important, the DCF calculation 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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Avon Protection, we've compiled three important factors you should further research:
Future Earnings: How does AVON'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.
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. 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.
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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.
