Today we’ll walk through one way to estimate the intrinsic value of National World Plc (LON:NWOR) by projecting its future cash flows and then discounting them to present value. One way to do this is to use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!

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 National World

The method

We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest 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 discount the value of these future cash flows to their estimated value in today’s dollars:

10-Year Free Cash Flow (FCF) Forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £26 million

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 6.2%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = £4.0 million × (1 + 0.9%) ÷ (6.2%–0.9%) = £76 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= UK £76 million ÷ (1 + 6.2%)^ten= UK £41 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 £67 million. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of UK £0.3, the company appears around fair value at the time of writing. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around 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 complete picture of a company’s potential performance. Since we consider National World 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 6.2%, which is based on a leveraged beta of 1.106. 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.

Next steps:

Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For National World, we’ve compiled three more things you should evaluate:

1. Risks: Take risks, for example – National World has 3 warning signs (and 1 which is significant) that we think you should know about.
2. 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!
3. Other top analyst picks: Interested to see what the analysts think? Take a look at our interactive list of analysts’ top stock picks to find out what they think could have attractive future prospects!

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.