Calculating The Intrinsic Value Of Drax Group plc (LON:DRX)

Simply Wall St.

Sat, Oct 20, 2018, 1:38 AM

I am going to run you through how I calculated the intrinsic value of Drax Group plc (LON:DRX) by taking the foreast future cash flows of the company and discounting them back to today’s value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for Drax Group by following the link below.

Check out our latest analysis for Drax Group

Crunching the numbers

I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow forecast

	2019	2020	2021	2022	2023
Levered FCF (£, Millions)	£202.25	£251.67	£131.00	£146.92	£164.77
Source	Analyst x4	Analyst x3	Analyst x1	Est @ 12.15%	Est @ 12.15%
Present Value Discounted @ 11.14%	£181.98	£203.74	£95.42	£96.29	£97.17

Present Value of 5-year Cash Flow (PVCF)= UK£675m

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (1.4%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 11.1%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = UK£165m × (1 + 1.4%) ÷ (11.1% – 1.4%) = UK£1.7b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = UK£1.7b ÷ ( 1 + 11.1%)⁵ = UK£1.0b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is UK£1.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of £4.24. Relative to the current share price of £4.1, the stock is about right, perhaps slightly undervalued at a 3.3% discount to what it is available for right now.

LSE:DRX Intrinsic Value Export October 20th 18

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Drax Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 11.1%, which is based on a levered beta of 1.132. This is derived from the Bottom-Up Beta method based on 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. For DRX, I’ve put together three important aspects you should further examine:

Financial Health: Does DRX 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.
Future Earnings: How does DRX’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: Are there other high quality stocks you could be holding instead of DRX? 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 for every stock on the LON every 6 hours. If you want to find the calculation for other stocks just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

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