Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Elementis plc (LON:ELM) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
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 still have some burning questions about this type of valuation, take a look at 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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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$30.3m
US$65.1m
US$88.0m
US$105.5m
US$120.7m
US$133.5m
US$144.2m
US$153.0m
US$160.3m
US$166.6m
Growth Rate Estimate Source
Analyst x2
Analyst x2
Analyst x2
Est @ 19.86%
Est @ 14.43%
Est @ 10.63%
Est @ 7.97%
Est @ 6.11%
Est @ 4.81%
Est @ 3.90%
Present Value ($, Millions) Discounted @ 7.7%
US$28.1
US$56.0
US$70.4
US$78.3
US$83.2
US$85.4
US$85.6
US$84.3
US$82.0
US$79.1
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$732m
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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.8b÷ ( 1 + 7.7%)10= US$1.3b
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 US$2.1b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK￡1.5, the company appears quite good value at a 46% 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.
dcf
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 Elementis 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 7.7%, which is based on a levered beta of 1.089. 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 Elementis
Strength
Debt is not viewed as a risk.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Chemicals market.
Opportunity
Annual earnings are forecast to grow faster than the British market.
Trading below our estimate of fair value by more than 20%.
Threat
Annual revenue is forecast to grow slower than the British market.
Next Steps:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Elementis, there are three pertinent elements you should explore:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ELM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
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.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
