Today we are going to review one way to estimate the intrinsic value of VRG SA (WSE: VRG) by taking expected future cash flows 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 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 review for VRG

The model

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. In the first step, we need to estimate the cash flow of the business over the next ten years. 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) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = zł372m

The second stage is also known as terminal value, this 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 of the 10-year government bond yield of 2.6%. We discount terminal cash flows to their present value at a cost of equity of 10%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = zł72m × (1 + 2.6%) ÷ (10% – 2.6%) = zł984m

Present value of terminal value (PVTV)= TV / (1 + r)^ten= zł984m ÷ (1 + 10%)^ten= zł375m

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is z 747 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of 3.3z, the company appears to be around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

Important assumptions

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 view VRG 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 10%, which is based on a leveraged beta of 1.360. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.

Looking forward:

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. It is not possible to achieve a rock-solid valuation with a DCF model. 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 the risk-free rate can have a significant impact on valuation. For VRG, we have put together three important things you need to assess:

1. Financial health: Does VRG have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future benefits: How does VRG’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.
3. 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. Simply Wall St updates its DCF calculation for every Polish stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This Simply Wall St article is general in nature. 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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