Are Telecom Plus Plc (LON:TEP) Investors Paying Above The Intrinsic Value?

editorial-team@simplywallst.com (Simply Wall St)

Tue, Nov 21, 2023, 11:03 PM 6 min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Telecom Plus Plc (LON:TEP) as an investment opportunity 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Telecom Plus

The Calculation

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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	-UK£113.6m	UK£69.3m	UK£79.6m	UK£69.1m	UK£63.1m	UK£59.5m	UK£57.4m	UK£56.2m	UK£55.7m	UK£55.6m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ -13.17%	Est @ -8.76%	Est @ -5.68%	Est @ -3.52%	Est @ -2.01%	Est @ -0.95%	Est @ -0.21%
Present Value (£, Millions) Discounted @ 6.2%	-UK£107	UK£61.4	UK£66.4	UK£54.2	UK£46.6	UK£41.3	UK£37.5	UK£34.6	UK£32.3	UK£30.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£298m

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 (1.5%) 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 6.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£56m× (1 + 1.5%) ÷ (6.2%– 1.5%) = UK£1.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£1.2b÷ ( 1 + 6.2%)¹⁰= UK£651m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£949m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£15.8, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf — LSE:TEP Discounted Cash Flow November 22nd 2023

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Telecom Plus 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 6.2%, 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.

SWOT Analysis for Telecom Plus

Strength

Earnings growth over the past year exceeded the industry.

Debt is not viewed as a risk.

Weakness

Dividend is low compared to the top 25% of dividend payers in the Integrated Utilities market.

Expensive based on P/E ratio and estimated fair value.

Opportunity

Annual earnings are forecast to grow for the next 3 years.

Threat

Dividends are not covered by earnings.

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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value lower than the current share price? For Telecom Plus, there are three essential factors you should assess:

Risks: Every company has them, and we've spotted 1 warning sign for Telecom Plus you should know about.
Future Earnings: How does TEP'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.