Does the June share price for Pets at Home Group Plc (LON:PETS) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the expected future cash flows and discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.

  We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

  Check out our latest analysis for at Home Group

  We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. 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, 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

  2021

  2022

  2023

  2024

  2025

  2026

  2027

  2028

  2029

  2030

  Levered FCF (£, Millions)

  UK£77.3m

  UK£84.1m

  UK£100.4m

  UK£115.1m

  UK£131.0m

  UK£138.0m

  UK£143.0m

  UK£147.0m

  UK£150.3m

  UK£153.1m

  Growth Rate Estimate Source

  Analyst x4

  Analyst x5

  Analyst x5

  Analyst x5

  Analyst x1

  Analyst x1

  Est @ 3.63%

  Est @ 2.82%

  Est @ 2.25%

  Est @ 1.85%

  Present Value (£, Millions) Discounted @ 8.2%

  UK£71.5

  UK£71.8

  UK£79.3

  UK£84.0

  UK£88.4

  UK£86.1

  UK£82.5

  UK£78.4

  UK£74.1

  UK£69.7

  (“Est”=FCF growth rate estimated by Simply Wall St)

  Present Value of 10-year Cash Flow (PVCF)=UK£785m

  We now need to calculate the Terminal Value, which accounts for all the 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 have used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. In the same way as with the 10-year ‘growth’ period, we discount future cash flows to today’s value, using a cost of equity of 8.2%.

  Terminal Value (TV)=FCF2030 × (1 + g) ÷ (r – g)=UK£153m× (1 + 0.9%) ÷ (8.2%– 0.9%)=UK£2.1b

  Present Value of Terminal Value (PVTV)=TV / (1 + r)10=UK£2.1b÷ ( 1 + 8.2%)10=UK£969m

  The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£1.8b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£4.6, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

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  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 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 at Home 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 accounts for debt. In this calculation we’ve used 8.2%, which is based on a levered beta of 1.368. 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.

  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. Rather it should be seen as a guide to “what assumptions need to 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 significantly impact the valuation. Can we work out why the company is trading at a premium to intrinsic value? For at Home Group, there are three additional items you should look at:

  Risks: We feel that you should assess the 2 warning signs for at Home Group we’ve flagged before making an investment in the company.

  Future Earnings: How does PETS’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!

  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.

  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 editorial-team (at) simplywallst.com.

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