Are Investors Undervaluing Adore Beauty Group Limited (ASX:ABY) By 27%?

Key Insights

• The projected fair value for Adore Beauty Group is AU$1.70 based on 2 Stage Free Cash Flow to Equity

• Adore Beauty Group's AU$1.25 share price signals that it might be 27% undervalued

• Our fair value estimate is 32% higher than Adore Beauty Group's analyst price target of AU$1.29

Today we will run through one way of estimating the intrinsic value of Adore Beauty Group Limited (ASX:ABY) by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

See our latest analysis for Adore Beauty Group

Is Adore Beauty Group 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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$4.06m	AU$5.09m	AU$6.02m	AU$6.83m	AU$7.53m	AU$8.11m	AU$8.60m	AU$9.02m	AU$9.38m	AU$9.71m
Growth Rate Estimate Source	Est @ 35.22%	Est @ 25.30%	Est @ 18.36%	Est @ 13.50%	Est @ 10.10%	Est @ 7.72%	Est @ 6.05%	Est @ 4.88%	Est @ 4.07%	Est @ 3.49%
Present Value (A$, Millions) Discounted @ 6.8%	AU$3.8	AU$4.5	AU$4.9	AU$5.2	AU$5.4	AU$5.5	AU$5.4	AU$5.3	AU$5.2	AU$5.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$50m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.2%) 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 6.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$9.7m× (1 + 2.2%) ÷ (6.8%– 2.2%) = AU$213m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$213m÷ ( 1 + 6.8%)¹⁰= AU$110m

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 AU$160m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$1.3, the company appears a touch undervalued at a 27% 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.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Adore Beauty 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 6.8%, which is based on a levered beta of 1.015. 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.

SWOT Analysis for Adore Beauty Group

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

Weakness

• No major weaknesses identified for ABY.

Opportunity

• Annual revenue is forecast to grow faster than the Australian market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings have declined over the past 5 years.

Looking Ahead:

Whilst important, the DCF calculation 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Adore Beauty Group, there are three important aspects you should explore:

1. Risks: Every company has them, and we've spotted 2 warning signs for Adore Beauty Group (of which 1 makes us a bit uncomfortable!) you should know about.

2. Future Earnings: How does ABY'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 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 Australian 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.