How far is ScS Group plc (LON:SCS) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. This will be done using the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
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 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.
See our latest analysis for ScS Group
Is the ScS Group correctly valued?
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, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (£, millions)||-UK£21.7m||UK£14.0m||UK£14.7m||UK£13.8m||UK£13.3m||UK£12.9m||UK£12.7m||UK£12.6m||UK£12.6m||UK£12.6m|
|Growth rate estimate Source||Analyst x1||Analyst x1||Analyst x1||Is @ -6.02%||Is @ -3.95%||East @ -2.5%||Is @ -1.49%||East @ -0.78%||East @ -0.28%||Is at 0.07%|
|Present value (£, millions) discounted at 11%||-UK£19.6||UK£11.5||UK£10.9||UK£9.2||UK£8.0||UK£7.1||UK£6.3||UK£5.7||UK£5.1||UK£4.6|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £48 million
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 11%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = £13 million × (1 + 0.9%) ÷ (11%–0.9%) = £132 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £132 million ÷ (1 + 11%)ten= UK £48 million
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is £96m. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of £2.0 in the UK, the company looks slightly undervalued at a 24% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.
Now, 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 consider ScS 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 11%, which is based on a leveraged beta of 2,000. 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.
Let’s move on :
Although important, the DCF calculation is just one of many factors you need to assess for a business. DCF models are not the be-all and end-all of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is the stock price below intrinsic value? For ScS Group, there are three additional things you should dig into:
- Risks: For example, we have identified 4 warning signs for ScS Group (1 cannot be ignored) which you should be aware of.
- Future earnings: How does the growth rate of SCS 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.
- 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 every stock on the LSE every day. If you want to find the calculation for other stocks, 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.