LON:GLEN) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.” data-reactid=”28″>Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Glencore plc (LON:GLEN) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.
Simply Wall St analysis model here may be something of interest to you.” data-reactid=”29″>Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Check out our latest analysis for Glencore ” data-reactid=”30″> Check out our latest analysis for Glencore
The method
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
| 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
| Levered FCF ($, Millions) | US$4.26b | US$4.94b | US$5.10b | US$5.72b | US$6.10b | US$6.41b | US$6.66b | US$6.87b | US$7.05b | US$7.20b |
| Growth Rate Estimate Source | Analyst x7 | Analyst x5 | Analyst x1 | Analyst x1 | Est @ 6.73% | Est @ 5.07% | Est @ 3.92% | Est @ 3.11% | Est @ 2.54% | Est @ 2.15% |
| Present Value ($, Millions) Discounted @ 11% | US$3.8k | US$4.0k | US$3.7k | US$3.7k | US$3.6k | US$3.4k | US$3.2k | US$2.9k | US$2.7k | US$2.5k |
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.2%. We discount the terminal cash flows to today’s value at a cost of equity of 11%.
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$59b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.7, the company appears quite undervalued at a 48% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
Important assumptions
We would point out that 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 inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Glencore 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 accounts for debt. In this calculation we’ve used 11%, which is based on a levered beta of 1.660. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Glencore, we’ve compiled three essential factors you should look at:
- Risks: For instance, we’ve identified 1 warning sign for Glencore that you should be aware of.
- Future Earnings: How does GLEN’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other Solid Businesses: 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 solid business fundamentals to see if there are other companies you may not have considered!
search here.” data-reactid=”70″>PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks just search here.
Get in touch with us directly. Alternatively, email [email protected].” data-reactid=”71″>This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email [email protected].
