K3 Capital Group PLC (LON:K3C)’s intrinsic value is potentially 51% higher than its stock price

Today we’re providing a simple walkthrough of a valuation method used to estimate the attractiveness of K3 Capital Group PLC (LON:K3C) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. One way to achieve this is to use the discounted cash flow (DCF) model. Believe it or not, it’s not too difficult to follow as you will see from our example!

We point out that there are many ways to value a company and, like DCF, each method has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of assessment, take a look at Simply Wall St’s analytics model.

Check out our latest analysis for K3 Capital Group

The calculation

We use the 2-phase growth model, which simply means that we consider two phases of company growth. In the initial phase, the company may have a higher growth rate and in the second phase, a stable growth rate is usually expected. First, we need to estimate cash flows over 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 latest estimate or reported value. We expect companies with declining free cash flow to slow their rate of contraction and companies with growing free cash flow to slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the early years than in later years.

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

10-year free cash flow (FCF) forecast.

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Leveraged FCF (£, million)

UK £6.95m

UK £14.0m

UK £13.3m

UK £12.9m

UK £12.7m

UK £12.5m

UK £12.5m

UK £12.5m

UK £12.5m

UK £12.5m

Source of growth rate estimate

Analyst x2

Analyst x2

Analyst x1

Estimated @ -3.03%

Estimated @ -1.86%

Estimated @ -1.04%

Estimated @ -0.46%

Estimated @ -0.06%

Estimated @ 0.22%

Estimated @ 0.42%

Present Value (£,million) Discounted @ 5.0%

UK£6.6

UK£12.7

UK£11.5

UK£10.6

UK£9.9

UK£9.3

UK£8.8

UK£8.4

UK£8.0

UK£7.7

(“Est” = FCF growth rate estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 93 million British pounds

We now need to calculate the terminal value, which takes into account all future cash flows after that ten-year period. A very conservative growth rate is used, which cannot exceed a country’s GDP growth, for a number of reasons. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. As with the 10-year “growth period,” we discount future cash flows to today’s value using a cost of equity rate of 5.0%.

final value (TV)= FCF2031 × (1 + g) ÷ (r – g) = £13m × (1 + 0.9%) ÷ (5.0% – 0.9%) = £305m

Present value of terminal value (PVTV)= TV / (1 + r)10= UK£305m÷ (1 + 5.0%)10= 187 million British pounds

The total value or equity value is then the sum of the present value of the future cash flows, which in this case is £280 million. In the final step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £2.5, the company appears fairly cheap at a 34% discount to the current share price. However, remember that this is only a rough estimate and like any complex formula – garbage in, garbage out.

DCF

Important Assumptions

We would like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is creating your own estimate of a company’s future performance, so try the calculation for yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs, so it does not provide a complete picture of a company’s potential performance. As we consider K3 Capital Group as a potential shareholder, the cost of equity is used as the discount rate and not the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we used 5.0% which is based on a leveraged beta of 0.858. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the industry average of global peers with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable business.

Continue:

While a company’s valuation is important, it’s just one of many factors you need to evaluate for a company. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as an indication of “which assumptions must be true for this stock to be under/overvalued”. For example, slightly adjusting the growth rate of the terminal value can dramatically change the overall result. What is the reason that the share price is below the intrinsic value? For K3 Capital Group, there are three key elements to consider:

  1. risks: For this purpose, you should inform yourself about the 2 warning signs we have sighted with K3 Capital Group (including 1 which is worrying).

  2. future earnings: How does K3C’s growth rate compare to its competitors and the broader market? Dive deeper into analyst consensus numbers for the years to come by interacting with our free analyst growth expectations chart.

  3. Other solid companies: Low debt, high returns on equity and good past performance are fundamental to a strong company. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered?

hp Simply Wall St updates its DCF calculation for each UK stock on a daily basis. So if you want to find the intrinsic value of another stock, just search here.

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

This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.

About Nina Snider

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