Are Investors Undervaluing Marks and Spencer Group plc (LON:MKS) By 35%?
Current share price of UK£3.68 suggests Marks and Spencer Group is potentially 35% undervalued
Analyst price target for MKS is UK£4.29 which is 24% below our fair value estimate
Does the March share price for Marks and Spencer Group plc (LON:MKS) 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. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.
View our latest analysis for Marks and Spencer Group
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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (£, Millions)
UK£386.8m
UK£454.4m
UK£489.6m
UK£559.0m
UK£575.0m
UK£589.4m
UK£603.8m
UK£618.3m
UK£633.0m
UK£647.9m
Growth Rate Estimate Source
Analyst x5
Analyst x3
Analyst x3
Analyst x1
Analyst x1
Est @ 2.51%
Est @ 2.45%
Est @ 2.40%
Est @ 2.37%
Est @ 2.35%
Present Value (£, Millions) Discounted @ 6.8%
UK£362
UK£398
UK£402
UK£430
UK£414
UK£397
UK£381
UK£365
UK£350
UK£335
("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = UK£3.8b
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 (2.3%) 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)= FCF2034 × (1 + g) ÷ (r – g) = UK£648m× (1 + 2.3%) ÷ (6.8%– 2.3%) = UK£15b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£15b÷ ( 1 + 6.8%)10= UK£7.6b
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£11b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£3.7, the company appears quite good value at a 35% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 Marks and Spencer 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 0.879. 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.
Strength
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Weakness
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 Consumer Retailing market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to grow slower than the British market.
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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. What is the reason for the share price sitting below the intrinsic value? For Marks and Spencer Group, there are three additional aspects you should consider:
Financial Health: Does MKS 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 MKS'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 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.
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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