Calculating The Intrinsic Value Of Balfour Beatty plc (LON:BBY)

Key Insights

• The projected fair value for Balfour Beatty is UK£4.81 based on 2 Stage Free Cash Flow to Equity
• With UK£5.50 share price, Balfour Beatty appears to be trading close to its estimated fair value
• Our fair value estimate is 3.5% lower than Balfour Beatty's analyst price target of UK£4.99

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Balfour Beatty plc (LON:BBY) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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Is Balfour Beatty Fairly Valued?

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (£, Millions)	UK£208.2m	UK£179.3m	UK£177.9m	UK£178.3m	UK£179.9m	UK£182.4m	UK£185.6m	UK£189.3m	UK£193.4m	UK£197.8m
Growth Rate Estimate Source	Analyst x4	Analyst x5	Est @ -0.78%	Est @ 0.22%	Est @ 0.92%	Est @ 1.40%	Est @ 1.74%	Est @ 1.98%	Est @ 2.15%	Est @ 2.27%
Present Value (£, Millions) Discounted @ 9.4%	UK£190	UK£150	UK£136	UK£124	UK£115	UK£106	UK£98.9	UK£92.2	UK£86.1	UK£80.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£1.2b

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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = UK£198m× (1 + 2.5%) ÷ (9.4%– 2.5%) = UK£3.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£3.0b÷ ( 1 + 9.4%)¹⁰= UK£1.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£2.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£5.5, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Balfour Beatty 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 9.4%, which is based on a levered beta of 1.339. 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.

View our latest analysis for Balfour Beatty

SWOT Analysis for Balfour Beatty

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Balfour Beatty, we've put together three additional factors you should explore:

1. Risks: Be aware that Balfour Beatty is showing 1 warning sign in our investment analysis , you should know about...
2. Future Earnings: How does BBY'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts 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 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.