Does the December share price for Jersey Electricity plc (LON:JEL) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Jersey Electricity

Step By Step Through The Calculation

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 begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (£, Millions)  UK£9.83m UK£9.45m UK£9.23m UK£9.10m UK£9.04m UK£9.02m UK£9.04m UK£9.08m UK£9.13m UK£9.19m Growth Rate Estimate Source Est @ -5.92% Est @ -3.85% Est @ -2.40% Est @ -1.38% Est @ -0.67% Est @ -0.17% Est @ 0.18% Est @ 0.42% Est @ 0.59% Est @ 0.71% Present Value (£, Millions) Discounted @ 5.4%  UK£9.3 UK£8.5 UK£7.9 UK£7.4 UK£6.9 UK£6.6 UK£6.2 UK£5.9 UK£5.7 UK£5.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£70m



We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 5.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£9.2m× (1 + 1.0%) ÷ (5.4%– 1.0%) = UK£208m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£208m÷ ( 1 + 5.4%)10= UK£123m

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£192m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£5.2, the company appears about fair value at a 18% 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

The 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 Jersey Electricity 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 5.4%, which is based on a levered beta of 0.800. 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 Jersey Electricity

Strength

Debt is not viewed as a risk.

Dividends are covered by earnings and cash flows.

Weakness

Earnings declined over the past year.

Dividend is low compared to the top 25% of dividend payers in the Electric Utilities market.

Opportunity

Current share price is below our estimate of fair value.

Threat

No apparent threats visible for JEL.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. For Jersey Electricity, we've compiled three important elements you should further research:

Risks: For instance, we've identified  2 warning signs for Jersey Electricity that you should be aware of. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for JEL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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. 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.

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.

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