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Is There An Opportunity With Wm Morrison Supermarkets PLC's (LON:MRW) 38% Undervaluation?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Wm Morrison Supermarkets PLC (LON:MRW) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Wm Morrison Supermarkets

Step by step through the calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF (£, Millions)

UK£319.1m

UK£361.4m

UK£399.7m

UK£367.0m

UK£368.0m

UK£367.7m

UK£368.1m

UK£368.9m

UK£370.1m

UK£371.5m

Growth Rate Estimate Source

Analyst x11

Analyst x11

Analyst x9

Analyst x1

Analyst x1

Est @ -0.08%

Est @ 0.1%

Est @ 0.23%

Est @ 0.32%

Est @ 0.38%

Present Value (£, Millions) Discounted @ 5.4%

UK£303

UK£325

UK£342

UK£298

UK£283

UK£268

UK£255

UK£242

UK£231

UK£220

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.8b

After calculating the present value of future cash flows in the intial 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 10-year government bond rate of 0.5%. We discount the terminal cash flows to today's value at a cost of equity of 5.4%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£372m× (1 + 0.5%) ÷ 5.4%– 0.5%) = UK£7.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£7.7b÷ ( 1 + 5.4%)10= UK£4.6b

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£7.3b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.9, the company appears quite good value at a 38% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

LSE:MRW Intrinsic value, January 20th 2020
LSE:MRW Intrinsic value, January 20th 2020

The 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 Wm Morrison Supermarkets 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 5.4%, which is based on a levered beta of 0.800. 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.

Next Steps:

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. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Wm Morrison Supermarkets, I've put together three fundamental factors you should further examine:

  1. Financial Health: Does MRW have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

  2. Future Earnings: How does MRW'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.

  3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of MRW? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every GB stock every day, so if you want to find the intrinsic value of any other stock just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.