Does the May share price for Johnson Service Group PLC (LON:JSG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (￡, Millions)
UK￡26.7m
UK￡49.8m
UK￡57.5m
UK￡63.1m
UK￡67.7m
UK￡71.6m
UK￡74.8m
UK￡77.5m
UK￡79.9m
UK￡82.1m
Growth Rate Estimate Source
Analyst x5
Analyst x5
Analyst x5
Est @ 9.73%
Est @ 7.34%
Est @ 5.67%
Est @ 4.50%
Est @ 3.68%
Est @ 3.11%
Est @ 2.71%
Present Value (￡, Millions) Discounted @ 7.1%
UK￡25.0
UK￡43.5
UK￡46.8
UK￡48.0
UK￡48.1
UK￡47.5
UK￡46.3
UK￡44.9
UK￡43.2
UK￡41.4
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = UK￡435m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK￡1.6b÷ ( 1 + 7.1%)10= UK￡794m
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￡1.2b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK￡1.6, the company appears quite good value at a 47% 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.
dcf
The Assumptions
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 Johnson Service 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 7.1%, which is based on a levered beta of 0.969. 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.
SWOT Analysis for Johnson Service Group
Strength
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Commercial Services market.
Opportunity
Annual earnings are forecast to grow faster than the British market.
Trading below our estimate of fair value by more than 20%.
Significant insider buying over the past 3 months.
Threat
Revenue is forecast to grow slower than 20% per year.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 discount to intrinsic value? For Johnson Service Group, there are three important aspects you should further examine:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for JSG's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
