Today, we’ll walk through one way to estimate the intrinsic value of The Children’s Place, Inc. (NASDAQ:PLCE) by taking 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. This may sound complicated, but it’s actually quite simple!
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
Check out our latest analysis for Children’s Place
Step by step through the calculation
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$152.0 million||$84.0 million||$53.3 million||$40.0 million||$33.2 million||$29.5 million||$27.3 million||$26.1 million||$25.4 million||$25.1 million|
|Growth rate estimate Source||Analyst x1||Analyst x1||Is @ -36.55%||East @ -25%||East @ -16.92%||East @ -11.26%||East @ -7.3%||East @ -4.53%||East @ -2.59%||Is @ -1.23%|
|Present value (in millions of dollars) discounted at 8.6%||$140||$71.3||$41.6||$28.8||$22.0||$18.0||$15.4||$13.5||$12.1||$11.0|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $373 million
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 8.6%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $25 million × (1 + 1.9%) ÷ (8.6%–1.9%) = $385 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= $385m ÷ (1 + 8.6%)ten= $169 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $542 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$33.0, the company looks slightly undervalued at a 21% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Children’s Place 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 factors in debt. In this calculation, we used 8.6%, which is based on a leveraged beta of 1.566. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value higher than the current stock price? For Children’s Place, we’ve rounded up three additional things you should dig into:
- Risks: For example, we found 2 warning signs for Children’s Place (1 is potentially serious!) that you should consider before investing here.
- Future earnings: How does PLCE’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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