Is there an opportunity with the 37% undervaluation of B&M European Value Retail SA (LON: BME)?
In this article, we will estimate the intrinsic value of B&M European Value Retail SA (LON: BME) projecting its future cash flows and then discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something that interests you.
Crunch the numbers
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) estimate
Leverage FCF (£, Million)
United Kingdom £ 458.8 million
United Kingdom £ 281.4 million
£ 340.7 million
United Kingdom £ 373.8 million
United Kingdom £ 397.1 million
United Kingdom £ 415.5 million
United Kingdom £ 430.1 million
UK £ 441.9m
United Kingdom £ 451.6m
United Kingdom £ 459.8 million
Source of estimated growth rate
East @ 6.23%
East @ 4.64%
Is @ 3.52%
East @ 2.74%
East @ 2.2%
East @ 1.81%
Present value (£, million) discounted at 5.7%
United Kingdom £ 434
United Kingdom £ 252
United Kingdom £ 288
United Kingdom £ 299
United Kingdom £ 301
UK £ 298
United Kingdom £ 292
United Kingdom £ 284
United Kingdom £ 274
United Kingdom £ 264
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 3.0 billion in the UK
We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. For a number of reasons, a very conservative growth rate is used that 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 their present value, using a cost of equity of 5.7%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK £ 460m × (1 + 0.9%) ÷ (5.7% –0.9%) = UK £ 9.7b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 9.7b ÷ (1 + 5.7%)ten= £ 5.6 billion in the UK
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is £ 8.6 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 5.4, the company looks fairly good value with a 37% 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 this in mind.
We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with these results, try the calculation yourself and play 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 B&M European Value Retail 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 into account the debt. In this calculation, we have used 5.7%, which is based on a leveraged beta of 1.013. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
To move on :
While a business valuation is important, ideally it won’t be the only analysis you review for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Can we understand why the company trades at a discount to its intrinsic value? For B&M European Value Retail, we have compiled three fundamental aspects that you should take a closer look at:
Risks: Concrete example, we have spotted 3 warning signs for B&M European Value Retail you need to be aware of it, and one of them is potentially serious.
Future benefits: How does BME’s growth rate compare to that of its peers and the broader market? Deepen the number of analyst consensus for the coming years by interacting with our free chart of analysts’ growth expectations.
Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with strong business fundamentals to see if there are other businesses you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every share on the LSE. If you want to find the calculation for other actions just search here.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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