Does This Valuation Of Luceco plc (LON:LUCE) Imply Investors Are Overpaying?

Key Insights

• The projected fair value for Luceco is UK£1.24 based on 2 Stage Free Cash Flow to Equity

• Luceco is estimated to be 34% overvalued based on current share price of UK£1.66

• The UK£1.92 analyst price target for LUCE is 55% more than our estimate of fair value

Does the June share price for Luceco plc (LON:LUCE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

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 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.

See our latest analysis for Luceco

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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£13.7m	UK£13.8m	UK£15.8m	UK£14.6m	UK£13.9m	UK£13.5m	UK£13.3m	UK£13.2m	UK£13.2m	UK£13.3m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ -7.75%	Est @ -4.89%	Est @ -2.89%	Est @ -1.49%	Est @ -0.51%	Est @ 0.17%	Est @ 0.65%
Present Value (£, Millions) Discounted @ 8.1%	UK£12.7	UK£11.8	UK£12.5	UK£10.7	UK£9.4	UK£8.4	UK£7.7	UK£7.1	UK£6.5	UK£6.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£93m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£13m× (1 + 1.8%) ÷ (8.1%– 1.8%) = UK£213m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£213m÷ ( 1 + 8.1%)¹⁰= UK£98m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£191m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£1.7, the company appears potentially overvalued at the time of writing. 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

The Assumptions

We would point out that 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 Luceco 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 8.1%, which is based on a levered beta of 1.160. 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 Luceco

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Electrical market.

Opportunity

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

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

• Significant insider buying over the past 3 months.

Threat

• Annual earnings are forecast to grow slower than the British market.

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value lower than the current share price? For Luceco, we've compiled three essential factors you should consider:

1. Risks: Be aware that Luceco is showing 1 warning sign in our investment analysis , you should know about...

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for LUCE's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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. 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.

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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.

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