In this article, we’ll estimate the intrinsic value of Cazoo Group Ltd (NYSE: CZOO) by taking the company’s future cash flow forecast and discounting it to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

Discover our latest analysis for the Cazoo group

The calculation

We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. 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, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 632 million in the 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 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 7.1%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = UK £ 339m × (1 + 2.0%) ÷ (7.1% -2.0%) = UK £ 6.7b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= UK £ 6.7b ÷ (1 + 7.1%)^ten= £ 3.4 billion in the UK

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 £ 4.0 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 6.0, the company appears to be roughly at fair value with a 16% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual 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 full picture of a company’s potential performance. Since we view Cazoo Group 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 7.1%, which is based on a leveraged beta of 1.051. 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 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 stock assessment 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 Cazoo Group, there are three relevant elements that you should consider further:

1. Risks: Every company has them, and we have spotted 3 warning signs for the Cazoo group (1 of which is of concern!) that you should know about.
2. Future benefits: How does CZOO’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 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 may not have considered!

PS. Simply Wall St updates its DCF calculation for every US 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. 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 any stock 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 any of the stocks mentioned.