Calculating The Intrinsic Value Of Babcock International Group PLC (LON:BAB)
Key Insights
- Using the 2 Stage Free Cash Flow to Equity, Babcock International Group fair value estimate is UK£13.56
- Babcock International Group's UK£14.41 share price indicates it is trading at similar levels as its fair value estimate
- Our fair value estimate is 3.5% higher than Babcock International Group's analyst price target of UK£13.11
In this article we are going to estimate the intrinsic value of Babcock International Group PLC (LON:BAB) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
The Model
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. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
| 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | 2034 | 2035 | |
| Levered FCF (£, Millions) | UK£209.3m | UK£213.3m | UK£239.3m | UK£325.0m | UK£362.3m | UK£394.7m | UK£422.9m | UK£447.8m | UK£470.3m | UK£491.1m |
| Growth Rate Estimate Source | Analyst x4 | Analyst x6 | Analyst x6 | Analyst x1 | Est @ 11.48% | Est @ 8.93% | Est @ 7.15% | Est @ 5.90% | Est @ 5.03% | Est @ 4.42% |
| Present Value (£, Millions) Discounted @ 8.1% | UK£194 | UK£182 | UK£189 | UK£238 | UK£245 | UK£247 | UK£245 | UK£240 | UK£233 | UK£225 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.2b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (3.0%) 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 8.1%.
Terminal Value (TV)= FCF2035 × (1 + g) ÷ (r – g) = UK£491m× (1 + 3.0%) ÷ (8.1%– 3.0%) = UK£9.9b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£9.9b÷ ( 1 + 8.1%)10= UK£4.5b
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£6.7b. 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£14.4, 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.
The Assumptions
Now the most important 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 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 Babcock International Group 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 8.1%, which is based on a levered beta of 1.007. 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 Babcock International Group
SWOT Analysis for Babcock International Group
- Earnings growth over the past year exceeded the industry.
- Debt is not viewed as a risk.
- Earnings growth over the past year is below its 5-year average.
- Dividend is low compared to the top 25% of dividend payers in the Aerospace & Defense market.
- Expensive based on P/E ratio and estimated fair value.
- Annual revenue is forecast to grow faster than the British market.
- Annual earnings are forecast to grow slower than the British market.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Babcock International Group, we've put together three further factors you should explore:
- Financial Health: Does BAB have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does BAB'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.
- 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.