Today we are going to walk through a way to estimate the intrinsic value of Marks Electrical Group PLC (LON:MRK) by estimating the future cash flows of the business and discounting them to their present value. This will be done using the discounted cash flow (DCF) model. This may sound complicated, but it’s 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.

Check out our latest analysis for Marks Electrical Group

Step by step through the calculation

We will use a two-stage 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 “sustained growth”. To begin with, we need to obtain cash flow estimates for 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:

10-Year Free Cash Flow (FCF) Forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £43 million

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 stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 0.9%. We discount terminal cash flows to present value at a cost of equity of 6.0%.

Terminal value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = £6.4 million × (1 + 0.9%) ÷ (6.0%–0.9%) = £127 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= £127 million ÷ (1 + 6.0%)^ten= UK £71 million

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £114 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 £0.7 in the UK, the company looks quite undervalued at a 36% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.

The hypotheses

We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Marks Electrical 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 6.0%, which is based on a leveraged beta of 1.049. 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.

Look forward:

While valuing a business is important, it ideally won’t be the only piece of analysis you look at for a business. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Marks Electrical Group, we have compiled three fundamentals that you should consider:

1. Risks: For example, we discovered 3 warning signs for Marks Electrical Group which you should be aware of before investing here.
2. Management:Did insiders increase their shares to take advantage of market sentiment about MRK’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
3. 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. Simply Wall St updates its DCF calculation for every UK stock daily, 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 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.