https://simplywall.st/news/2017/02/17/a ... lc-lsermg/
In this article I am going to calculate the intrinsic value of Royal Mail (LSE:RMG) using a method called discounted cash flow or DCF. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity by taking the expected Future Cash Flows and discounting them to their present valye. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model
If you are reading this and its not February 2017 then I highly recommend you check out the latest calculation for Royal Mail by following the link below.
Check out our latest analysis for Royal Mail
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To begin with we have to get estimates of the next 5 years of cash flows, for this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
Step by step through the calculation
Please note that the numbers here are in millions apart from the per share values.
5-year cash flow estimate
2017 2018 2019 2020 2021
Levered FCF (GBP, Millions) £308.77 £386.66 £375.63 £332.60 £329.70
Source Analyst x7 Analyst x8 Analyst x6 Analyst x1 Analyst x1
Present Value Discounted @ 8.3% £285.11 £329.68 £295.74 £241.79 £221.32
Present value of next 5 years cash flows: £1,374
After calculating the present value of 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 1st stage. For a number of reasons a very conservative rate is used that cannot exceed that of the GDP. In this case I have used the 10 year government bond rate (1.5%). In the same way as with the 5 year ‘growth’ period we discount this to today’s value.
Terminal Value = FCF2021 × (1 + g) ÷ (Discount Rate – g)
Terminal Value = £330 × (1 + 1.5%) ÷ (8.3% – 1.5%)
Terminal value based on the Perpetuity Method where growth (g) = 1.5%: £4,915
Present value of terminal value: £3,299
So the total value is the sum of the next 5 years cash flows and the terminal value discounted to today, this is known as the Equity Value.
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = £1,374 + £3,299 = £4,673
In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number.
Value = Total value / Shares Outstanding (£4,672.93 / 993.66)
Value per share: £4.7
Now when we compare the intrinsic value of 4.7 to the current share price of £4.1 we see Royal Mail (LSE:RMG) is a touch undervalued at a 13% discount to what it is available for right now.
I’d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Royal Mail as potential investors the Cost of Equity is used as the discount rate, not the Cost of Capital (or Weighed Average Cost of Capital/ WACC) which accounts for debt.
In this calculation I’ve used 8.3% and this is based on a Levered Beta of 0.8. I’m not going to go into how I calculate the Levered Beta in detail, I used the ‘Bottom up Beta’ method based on the comparable businesses, I also impose a limit between 0.8 and 2 which is a reasonable range for a stable business. Google this if you want to learn more.