Australia markets closed
  • ALL ORDS

    7,258.90
    -23.20 (-0.32%)
     
  • AUD/USD

    0.7728
    -0.0000 (-0.00%)
     
  • ASX 200

    6,997.50
    -20.30 (-0.29%)
     
  • OIL

    61.82
    -0.85 (-1.36%)
     
  • GOLD

    1,781.40
    +3.00 (+0.17%)
     
  • BTC-AUD

    71,307.88
    -480.10 (-0.67%)
     
  • CMC Crypto 200

    1,256.03
    +21.61 (+1.75%)
     

An Intrinsic Calculation For BAE Systems plc (LON:BA.) Suggests It's 26% Undervalued

Simply Wall St
·6-min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of BAE Systems plc (LON:BA.) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for BAE Systems

The calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of 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

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF (£, Millions)

UK£1.20b

UK£1.48b

UK£1.57b

UK£1.73b

UK£1.58b

UK£1.50b

UK£1.44b

UK£1.41b

UK£1.40b

UK£1.39b

Growth Rate Estimate Source

Analyst x13

Analyst x12

Analyst x6

Analyst x2

Analyst x1

Est @ -5.42%

Est @ -3.5%

Est @ -2.15%

Est @ -1.2%

Est @ -0.54%

Present Value (£, Millions) Discounted @ 7.6%

UK£1.1k

UK£1.3k

UK£1.3k

UK£1.3k

UK£1.1k

UK£962

UK£863

UK£784

UK£720

UK£665

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

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 (1.0%) 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 7.6%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£1.4b× (1 + 1.0%) ÷ (7.6%– 1.0%) = UK£21b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£21b÷ ( 1 + 7.6%)10= UK£10b

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£20b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£4.7, the company appears a touch undervalued at a 26% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
dcf

The 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 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 accounts for debt. In this calculation we've used 7.6%, which is based on a levered beta of 1.113. 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.

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for 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 the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For BAE Systems, we've put together three important elements you should look at:

  1. Risks: For instance, we've identified 1 warning sign for BAE Systems that you should be aware of.

  2. Future Earnings: How does BA.'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.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.