Calculation of the fair value of DCD Media Plc (LON: DCD)
Today we will review a valuation method used to estimate the attractiveness of DCD Media Plc (LON: DCD) as an investment opportunity by estimating the company’s future cash flows and discounting them to their current value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. Anyone who wants to learn a little more about intrinsic value should read the Simply Wall St.
Check out our latest analysis for DCD Media
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. 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.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (£, Million)||United Kingdom £ 420.8k||£ 370.6k||£ 340.6k in UK||United Kingdom £ 322.3k||United Kingdom £ 311.1k||United Kingdom £ 304.3k||£ 300.6k||United Kingdom £ 298.8k||United Kingdom £ 298.4k||United Kingdom £ 298.9k|
|Source of estimated growth rate||Is @ -17.44%||Is @ -11.93%||Is @ -8.08%||Is @ -5.38%||Is @ -3.49%||East @ -2.17%||Is @ -1.24%||East @ -0.59%||East @ -0.14%||Est @ 0.18%|
|Present value (£, million) discounted at 6.3%||United Kingdom £ 0.4||United Kingdom £ 0.3||United Kingdom £ 0.3||United Kingdom £ 0.3||UK £ 0.2||UK £ 0.2||UK £ 0.2||UK £ 0.2||UK £ 0.2||UK £ 0.2|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 2.0million in UK
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 6.3%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK £ 299,000 × (1 + 0.9%) ÷ (6.3% – 0.9%) = UK £ 5.7 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 5.7m ÷ (1 + 6.3%)ten= £ 3.1 million in the UK
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £ 5.1million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 1.9, the company appears to be roughly at fair value with a 7.6% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 DCD Media 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 into account debt. In this calculation, we used 6.3%, which is based on a leveraged beta of 1.005. 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.
To move on :
While a business valuation is important, ideally it won’t be the only analysis you review 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. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For DCD Media, there are three other factors to consider:
- Risks: Concrete example, we have spotted 2 warning signs for DCD Media you need to be aware of it, and one of them is a little rude.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
- Other environmentally friendly companies: Are you concerned about the environment and think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover stocks you may not have thought of!
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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