Topps Tiles Plc (LON:TPT) shares could be 41% below their estimated intrinsic value

Key findings

• The estimated fair value of Topps Tiles is 0.77 GBP based on the 2-step Free Cash Flow to Equity
• The current share price of 0.45 GBP suggests that Topps Tiles may be undervalued by 41%
• The analyst price target for TPT is GBP 0.62, which is 19% below our fair value estimate.

How far is Topps Tiles Plc (LON:TPT) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by taking the expected future cash flows and discounting them to their present value. To do this, we will 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 would like to point out that there are many ways to value a company and that each method, such as the DCF, has advantages and disadvantages in certain scenarios. For those who like to engage in stock analysis, the analysis model presented here by Simply Wall St might be of interest.

Check out our latest analysis for Topps Tiles

The calculation

We use the two-stage growth model, which simply means that we consider two stages of the company’s growth. In the early stage, the company might have a higher growth rate, and in the second stage, a stable growth rate is usually assumed. First, we need to estimate the next ten years’ cash flows. Where possible, we use analyst estimates, but when these are not 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, we need to discount the sum of these future cash flows to arrive at an estimate of present value:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = £74 million

The second phase is also called the terminal value, which is the company’s cash flow after the first phase. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year Treasury yield of 1.8%. We discount the terminal cash flows to today’s value using a cost of equity of 11%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = £18 million × (1 + 1.8%) ÷ (11% – 1.8%) = £208 million

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= £208 million ÷ (1 + 11%)¹⁰= £77 million

The total value or equity value is then the sum of the present value of future cash flows, which in this case is £151 million. To get the intrinsic value per share, we divide this by the total number of shares in issue. Compared to the current share price of £0.5, the company appears quite undervalued at a 41% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it is better to consider this as a rough estimate that is not accurate to the last penny.

The assumptions

The key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with these results, try the calculation yourself and play with the assumptions. 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’re looking at Topps Tiles 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 11%, which is based on a leveraged beta of 1.593. 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 a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Topps Tiles

Looking ahead:

Valuation is only one side of the coin in building your investment thesis and just one of many factors you need to evaluate 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 the company being undervalued or overvalued. For example, changes in the company’s cost of equity or risk-free interest rate can significantly affect the valuation. What is the reason for the stock price being below the intrinsic value? For Topps Tiles, we have compiled three important aspects for you to examine:

1. Risks: For this purpose, you should consult the 2 warning signs we discovered them at Topps Tiles.
2. Future income: How does TPT’s growth rate compare to its 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 Simply Wall St updates its DCF calculation for each UK stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment solely on the basis of 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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