Home Discount rate An intrinsic calculation for Similar Group plc (LON:LIKE) suggests it is 42% undervalued

An intrinsic calculation for Similar Group plc (LON:LIKE) suggests it is 42% undervalued

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Today we are going to give a simple overview of a valuation method used to estimate the attractiveness of Like Group plc (LON:LIKE) as an investment opportunity by taking future cash flows expected and discounting them to their present value. This will be done using the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.

Discover our latest analysis for the Like Group

What is the estimated valuation?

We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less 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

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Leveraged FCF (£, millions)

UK£2.60m

UK£4.93m

UK£5.76m

UK£6.45m

UK£7.00m

UK£7.45m

UK£7.79m

UK£8.07m

UK£8.29m

UK£8.47m

Growth rate estimate Source

Analyst x1

Analyst x1

East @ 16.73%

Is 11.98%

Is at 8.65%

Is at 6.32%

Is at 4.69%

Is at 3.54%

Is at 2.74%

Is at 2.19%

Present value (£, million) discounted at 6.1%

UK£2.4

UK£4.4

UK£4.8

UK£5.1

UK£5.2

UK£5.2

UK£5.1

UK£5.0

UK£4.9

UK£4.7

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £46 million

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 0.9%. We discount terminal cash flows to present value at a cost of equity of 6.1%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = £8.5 million × (1 + 0.9%) ÷ (6.1%–0.9%) = £163 million

Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £163 million ÷ (1 + 6.1%)ten= UK £90 million

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is £136 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £0.3 in the UK, the company looks quite undervalued at a 42% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

dcf

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider the Likel Group 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 takes debt into account. In this calculation, we used 6.1%, which is based on a leveraged beta of 1.086. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or in the risk-free rate can have a significant impact on the valuation. Why is the stock price below intrinsic value? For Similar Group, there are three relevant factors that you should examine in more detail:

  1. Risks: Take for example the ubiquitous specter of investment risk. We have identified 1 warning sign with Like Group, and understanding it should be part of your investment process.

  2. Future earnings: How does LIKE’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.

  3. Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of ​​what you might be missing!

PS. The Simply Wall St app performs an updated cash flow valuation for every stock on AIM every day. If you want to find the calculation for other stocks, search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.