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Key Insights

• Fernheizwerk Neukölln's estimated fair value is €32.61 based on Dividend Discount Model

• Current share price of €27.20 suggests Fernheizwerk Neukölln is potentially trading close to its fair value

• The average premium for Fernheizwerk Neukölln's competitorsis currently 223%

Today we will run through one way of estimating the intrinsic value of Fernheizwerk Neukölln Aktiengesellschaft (FRA:FHW) by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

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 Fernheizwerk Neukölln

Is Fernheizwerk Neukölln Fairly Valued?

We have to calculate the value of Fernheizwerk Neukölln slightly differently to other stocks because it is a water utilities company. In this approach dividends per share (DPS) are used, as free cash flow is difficult to estimate and often not reported by analysts. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.7%. We then discount this figure to today's value at a cost of equity of 4.4%. Relative to the current share price of €27.2, the company appears about fair value at a 17% 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.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= €1.2 / (4.4% – 0.7%)

= €32.6

Important 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. 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 Fernheizwerk Neukölln 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 4.4%, which is based on a levered beta of 0.800. 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.