Fair value calculation of BAE Systems plc (LON:BA.)

Key findings

• Using the 2-step free cash flow to equity, the estimated fair value of BAE Systems is GBP 13.02.
• BAE Systems’ share price of £13.28 suggests the company is trading at a similar level to its estimated fair value
• The analyst price target of GBP 14.16 for BA is 8.8% above our fair value estimate.

Today we’re going to go through one way to estimate the intrinsic value of BAE Systems plc (LON:BA.) by taking the company’s forecast future cash flows and discounting them to today’s value. One way to do this is by applying the Discounted Cash Flow (DCF) model. There’s actually not too much involved in it, even though it might seem quite complex.

Companies can be valued in many ways, so we would like to point out that a DCF is not perfect for every situation. If you want to learn more about intrinsic value, you should take a look at Simply Wall St’s analysis model.

Check out our latest analysis for BAE Systems

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 get estimates of the next ten years of 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 discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = £15 billion

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 at a cost of equity of 6.6%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = £2.2 billion × (1 + 1.8%) ÷ (6.6% – 1.8%) = £46 billion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= £46 billion ÷ (1 + 6.6%)¹⁰= £24 billion

The total value is the sum of the next ten years’ cash flows plus the discounted terminal value, giving the total equity value, which in this case is £39 billion. The final step is to divide the equity value by the number of shares in issue. Relative to the current share price of £13.3, the company seems about fair at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s better to consider this a rough estimate that isn’t accurate to the last penny.

Important assumptions

We would like to point out that the key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs and therefore does not provide a complete picture of a company’s potential performance. Since we consider BAE Systems 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 6.6%, which is based on a leveraged beta of 0.889. 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 BAE Systems

Next Steps:

While the DCF calculation is important, it is only one of many factors you need to evaluate a company. The DCF model is not a perfect tool for stock valuation. 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. If a company grows at a different rate, or if its cost of equity or risk-free rate changes significantly, the outcome may look very different. For BAE Systems, we have compiled three other elements you should further investigate:

1. Financial health: Does BA. have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as debt and risk.
2. Future income: How does BA’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 high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

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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