Is there a chance in the 46% undervaluation of Ashtead Group plc (LON: AHT)?

How far is Ashtead Group plc (LON: AHT) from its intrinsic value? Using the latest financial data, we check if the stock is fairly valued by forecasting its future cash flows and then discounting it to today’s value. Our analysis will use the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually very simple!

Remember, however, that there are many ways to appreciate a company’s value, and a DCF is just one method. If you still have some burning questions about this type of assessment, take a look at those Simply Wall St analytical model.

Check out our latest analysis for the Ashtead Group

Crack the numbers

We use what is called a 2-step model, which simply means that we have two different growth periods for the company’s cash flows. In general, the first stage is higher growth and the second stage is lower growth phase. First, we need to estimate the cash flows for the next ten years. We use analyst estimates wherever possible, but when these are not available we extrapolate the previous free cash flow (FCF) from the most recent estimate or reported value. We assume that companies with falling free cash flow will slow their rate of contraction and that companies with increasing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the first few years than in later years.

In general, we assume that a dollar today is more valuable than a dollar in the future, and the sum of these future cash flows is then discounted to today’s value:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = UK £ 13bn

The second stage is also known as Terminal Value, this is the company’s cash flow after the first stage. The Gordon growth formula is used to calculate the terminal value using a future annual growth rate equal to the 5-year average 10-year government bond yield of 0.9%. We discount the terminal cash flows to today’s value using a cost of equity rate of 7.3%.

Final value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK £ 3.6bn × (1 + 0.9%) ÷ (7.3% – 0.9%) = UK £ 57bn

Present value of the final value (PVTV)= TV / (1 + r)¹⁰= 57 billion pounds sterling (1 + 7.3%)¹⁰= £ 28 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £ 42 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of £ 50.0, the company looks fairly undervalued at a discount of 46% on the current share price. Remember, however, that this is only an approximate rating, and like any complex formula – garbage in, garbage out.

The assumptions

We point out that the most important input factors for a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and review your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital requirements of a company, so that it does not provide a complete picture of a company’s potential performance. Since we view the Ashtead 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) that accounts for debt. In this calculation we used 7.3% based on a leveraged beta of 1.196. Beta is a measure of the volatility of a stock compared to the overall market. 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 stable business.

Looking ahead:

While rating a company is important, it shouldn’t be the only metric you consider when looking for a company. The DCF model is not a perfect tool for stock valuation. Instead, the best use for a DCF model is to test certain assumptions and theories to see if they would lead to an under- or over-valuation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is the intrinsic value higher than the current share price? For the Ashtead Group, we’ve put together three relevant elements that you should check out:

1. Risks: You should be aware of this 1 warning sign for Ashtead Group We uncovered before we even consider investing in the company.
2. Future income: What is AHT’s growth rate compared to competitors and the broader market? Learn more about analyst consensus numbers for the years to come by interacting with our free analyst growth expectations chart.
3. Other solid deals: Low debt, high returns on equity, and good past performance are fundamental to a strong company. Explore our interactive list of stocks with a solid business foundation to see if there are any other companies you might not have considered!

PS. Simply Wall St updates its DCF calculation for every UK share on a daily basis. So if you want to find out the intrinsic value of any other stock, just search here.

Funded
When trading with the Ashtead Group or any other investment, use the platform considered by many to be the professional gateway to the world market. Interactive brokers. Get the cheapest * trading in stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.

This article from Simply Wall St is of a general nature. It is not a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our goal is to provide you with long-term, focused analysis based on fundamentals. Note that our analysis may not take into account the latest company announcements or quality material, which may be sensitive to the price. Simply Wall St has no position in the stocks mentioned.
^*Interactive Brokers is rated the cheapest broker by StockBrokers.com

Do you have any feedback on this article? Concerned about the content? Get in touch directly with us. Alternatively, send an email to the editorial team (at) simplywallst.com.