Inchcape plc (LON:INCH)’s intrinsic value may be 81% above its share price

Key findings

• The forecast fair value for Inchcape is £13.62 based on 2-step free cash flow to equity
• Inchcape’s UK share price of £7.53 suggests the company could be undervalued by 45%
• The analyst price target for INCH is GBP 10.87, 20% below our fair value estimate.

Does Inchcape plc (LON:INCH)’s share price in June reflect its actual value? Today we’ll estimate the stock’s intrinsic value by taking the company’s forecast future cash flows and discounting them to today’s value. To do this, we’ll use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without its flaws. Anyone interested in learning more about intrinsic value should check out Simply Wall St’s analysis model.

Check out our latest analysis for Inchcape

Processing the numbers

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally speaking, the first stage is one of higher growth, and the second stage is one of lower growth. The first stage requires us to estimate the company’s cash flows for the next ten years. 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, the sum of these future cash flows is 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) = GBP 3.0 billion

After calculating the present value of future cash flows in the first 10-year period, we need to calculate the terminal value, which takes into account all future cash flows after the first period. For various reasons, a very conservative growth rate is used, which cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.8%) 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 9.7%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = £521 million × (1 + 1.8%) ÷ (9.7% – 1.8%) = £6.7 billion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= £6.7 billion ÷ (1 + 9.7%)¹⁰= £2.7 billion

The total value or equity value is then the sum of the present value of future cash flows, which in this case is £5.6 billion. The final step is to divide the equity value by the number of shares in issue. Compared to the current share price of £7.5, the company appears quite undervalued at a 45% discount to the current share price. However, remember that this is only an approximate valuation and as with any complex formula, where there’s rubbish in, there’s rubbish out.

Important assumptions

The main 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 repeating the calculations yourself and playing around with them. The DCF also doesn’t take into account the potential cyclicality of an industry or a company’s future capital needs and therefore doesn’t provide a complete picture of a company’s potential performance. Since we consider Inchcape 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 takes debt into account. In this calculation, we used 9.7%, which is based on a leveraged beta of 1.446. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Inchcape

Looking ahead:

Although the valuation of a company is important, ideally it should not be the only analysis you look at for a company. It is not possible to get a foolproof valuation using a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. For example, slightly adjusting the growth rate of the terminal value can dramatically change the overall result. Why is the intrinsic value higher than the current share price? For Inchcape, there are three relevant factors you should consider:

1. Risks: Consider, for example, the ever-present specter of investment risk. We have identified 2 warning signs with Inchcape (at least 1, which makes us a little uncomfortable), and understanding these should be part of your investment process.
2. Future income: How does INCH’s growth rate compare to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.
3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS The Simply Wall St app does 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.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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