A look at the fair value of Pan African Resources PLC (LON: PAF)
Today we are going to review a valuation method used to estimate the attractiveness of Pan African Resources PLC (LON: PAF) as an investment opportunity by projecting its future cash flows and then discounting them. at the current value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too hard to follow, as you will see in our example!
We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
See our latest analysis for Pan-African resources
Crunch the numbers
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year free cash flow (FCF) forecast
|Leverage FCF ($, Millions)||US $ 32.0 million||US $ 37.0 million||US $ 40.6 million||US $ 43.4 million||US $ 45.6 million||US $ 47.4 million||$ 48.9 million||US $ 50.0 million||US $ 51.0 million||$ 51.8 million|
|Source of estimated growth rate||Analyst x1||Analyst x1||Est @ 9.62%||Est @ 7.01%||Est @ 5.18%||East @ 3.9%||East @ 3.01%||East @ 2.38%||Est @ 1.94%||East @ 1.64%|
|Present value (in millions of dollars) discounted at 9.7%||US $ 29.2||$ 30.8||$ 30.7||US $ 30.0||$ 28.7||US $ 27.2||$ 25.6||$ 23.9||US $ 22.2||$ 20.5|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 268 million
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.9%. We discount the terminal cash flows to their present value at a cost of equity of 9.7%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 52 million × (1 + 0.9%) ÷ (9.7% – 0.9%) = US $ 596 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 596 million ÷ (1 + 9.7%)ten= US $ 236 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $ 504 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current UK £ 0.2 share price, the company appears to be roughly at fair value with a 7.7% discount to where the share price is currently trading . Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 full picture of a company’s potential performance. Since we consider Pan African Resources 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 9.7%, which is based on a leveraged beta of 1.150. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. DCF models are not the alpha and omega of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Pan African Resources, we have compiled three important things you should consider:
- Risks: Take risks, for example – Pan African Resources a 2 warning signs we think you should be aware.
- Future benefits: How does PAF’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each AIM share. If you want to find the calculation for other actions, just 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 using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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