In this article, we will estimate the intrinsic value of Endesa, SA (BME:ELE) by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.

See our latest analysis for Endesa

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 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.

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) Forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leveraged FCF (€, Millions) €739.3 million €1.01 billion €958.0m €1.03 billion €1.33 billion €1.42 billion €1.50 billion €1.56 billion €1.60 billion €1.64 billion
Growth rate estimate Source Analyst x9 Analyst x9 Analyst x8 Analyst x4 Analyst x2 Is at 6.97% Is at 5.13% Is at 3.85% Is 2.95% Is at 2.32%
Present value (€, millions) discounted at 5.5% 701 € 906 € 816 € 830 € €1.0k €1.0k €1.0k €1.0k 988 € 958 €

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = €9.3 billion

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. 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 (0.9%) 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 5.5%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = €1.6 billion × (1 + 0.9%) ÷ (5.5%–0.9%) = €35 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= €35bn÷ ( 1 + 5.5%)ten= 21 billion euros

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 30 billion euros. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of €21.0, the company looks slightly undervalued at a 26% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.

BME: ELE Cash Flow Update May 27, 2022

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around 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 complete picture of a company’s potential performance. Since we consider Endesa 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 5.5%, which is based on a leveraged beta of 0.800. 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 a business valuation is important, it shouldn’t be the only metric to consider when researching a business. 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. For example, changes in the company’s cost of equity or in the risk-free rate can have a significant impact on the valuation. Can we understand why the company is trading at a discount to its intrinsic value? For Endesa, there are three relevant aspects to consider:

  1. Risks: For example, we discovered 3 warning signs for Endesa (2 are concerning!) that you should be aware of before investing here.
  2. Future earnings: How does ELE’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. The Simply Wall St app performs an updated cash flow valuation for each BME stock every day. If you want to find the calculation for other stocks, search here.

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.