Today we are going to walk through a way to estimate the intrinsic value of Signify NV (AMS:LIGHT) by estimating the company’s future cash flows and discounting them to their present 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.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.

See our latest analysis for Signify

Step by step in the calculation

We use what is called a 2-stage 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. To start, we need to estimate the cash flows 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:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = €5.0 billion

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which 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 (0.09%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 5.9%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = €686M × (1 + 0.09%) ÷ (5.9%– 0.09%) = €12B

Present value of terminal value (PVTV)= TV / (1 + r)^ten= €12bn÷ ( 1 + 5.9%)^ten= €6.7 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 12 billion euros. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of €47.1, the company looks like a pretty good value at a 49% 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 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 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 Signify 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 factors in debt. In this calculation, we used 5.9%, which is based on a leveraged beta of 1.371. 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:

Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is the stock price below intrinsic value? For Signify, we’ve put together three essential things you need to assess:

1. Risks: Be aware that Signify displays 3 warning signs in our investment analysis you should know…
2. Future earnings: How does LIGHT’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of ​​what you might be missing!

PS. Simply Wall St updates its DCF calculation for every Dutch stock daily, so if you want to find the intrinsic value of any other stock, just search here.

Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.

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.