Today we are going to review a valuation method used to estimate the attractiveness of Vera Bradley, Inc. (NASDAQ: VRA) as an investment opportunity by taking expected future cash flows and determining them. discounting to today’s value. Our analysis will use the discounted cash flow (DCF) model. It may sound complicated, but it’s actually quite simple!

We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

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. 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.

In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present 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) = US $ 216 million

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 7.5%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 32 million × (1 + 2.0%) ÷ (7.5% to 2.0%) = US $ 605 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 605 million ÷ (1 + 7.5%)^ten= US $ 295 million

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 511 million. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of $ 12.2, the company appears to be roughly at fair value with a 19% discount from 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.

NasdaqGS: Discounted Cash Flow VRA July 6, 2021

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. If you don’t agree with these results, try the calculation yourself and play with the 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 view Vera Bradley as a potential shareholder, 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 7.5%, which is based on a leveraged beta of 1.158. 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.

Next steps:

While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. The DCF model is not a perfect equity valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Vera Bradley, there are three more things you should research further:

1. Risks: Know that Vera Bradley shows 1 warning sign in our investment analysis , you must know…
2. Future benefits: How does VRA’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
3. 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!

PS. The Simply Wall St app performs a daily discounted cash flow valuation for each NASDAQGS share. If you want to find the calculation for other actions, just search here.

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 material. Simply Wall St has no position in the mentioned stocks.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.