Inchcape plc's (LON:INCH) Intrinsic Value Is Potentially 53% Above Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Inchcape fair value estimate is UK£10.78
• Inchcape's UK£7.03 share price signals that it might be 35% undervalued
• Our fair value estimate is 8.5% higher than Inchcape's analyst price target of UK£9.93

Today we will run through one way of estimating the intrinsic value of Inchcape plc (LON:INCH) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

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The Calculation

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. In the first stage we need to estimate the cash flows to the business over 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 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (£, Millions)	UK£314.7m	UK£343.6m	UK£355.4m	UK£330.7m	UK£316.9m	UK£309.8m	UK£307.1m	UK£307.4m	UK£309.6m	UK£313.4m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x4	Est @ -6.95%	Est @ -4.18%	Est @ -2.23%	Est @ -0.87%	Est @ 0.08%	Est @ 0.74%	Est @ 1.21%
Present Value (£, Millions) Discounted @ 8.8%	UK£289	UK£290	UK£276	UK£236	UK£207	UK£186	UK£170	UK£156	UK£144	UK£134

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.1b

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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = UK£313m× (1 + 2.3%) ÷ (8.8%– 2.3%) = UK£4.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£4.9b÷ ( 1 + 8.8%)¹⁰= UK£2.1b

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£4.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£7.0, the company appears quite undervalued at a 35% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 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 accounts for debt. In this calculation we've used 8.8%, which is based on a levered beta of 1.276. 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.

Check out our latest analysis for Inchcape

SWOT Analysis for Inchcape

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Inchcape, there are three further elements you should further research:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Inchcape .
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for INCH's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. 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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock 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.