A look at the intrinsic value of BAE Systems plc (LON: BA.)
Today we are going to take a simple walkthrough of a valuation method used to estimate the attractiveness of BAE Systems plc (LON:BA.) as an investment opportunity by taking expected future cash flows and discounting them to their current value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are actually quite simple.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. 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.
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Is BAE Systems valued at its fair value?
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. In the first step, we need to estimate the company’s cash flow over 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, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (£, millions)||UK£1.63b||UK£1.82b||UK£2.01b||UK£1.80b||UK£1.67b||UK£1.59b||UK£1.55b||UK£1.52b||UK£1.50b||UK£1.50b|
|Growth rate estimate Source||Analyst x8||Analyst x7||Analyst x4||Analyst x1||East @ -7.04%||Is @ -4.63%||Is @ -2.94%||Is @ -1.76%||East @ -0.94%||Is @ -0.36%|
|Present value (£, million) discounted at 6.2%||UK£1.5k||UK£1.6k||UK£1.7k||UK£1.4k||UK£1.2k||UK£1.1k||UK£1.0k||UK£936||UK£873||UK£818|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £12 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 1.0%. We discount terminal cash flows to present value at a cost of equity of 6.2%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = £1.5 billion × (1 + 1.0%) ÷ (6.2%–1.0%) = £29 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK£29b÷ ( 1 + 6.2%)ten= UK £16 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £28 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of £8.2 in the UK, the company appears to be about fair value at a 9.4% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. 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 complete picture of a company’s potential performance. Since we consider BAE Systems 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 6.2%, which is based on a leveraged beta of 0.898. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For BAE Systems, we have compiled three essential aspects that you should assess:
- Financial health: Does BA. have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
- Future earnings: How the growth rate of BA. does it compare to its peers and the wider market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs an updated cash flow valuation for every stock on the LSE 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.