Is Topps Tiles Plc (LON:TPT) Trading At A 47% Discount?

Key Insights

• Topps Tiles' estimated fair value is UK£0.82 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£0.44 suggests Topps Tiles is potentially 47% undervalued

• The UK£0.72 analyst price target for TPT is 12% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Topps Tiles Plc (LON:TPT) by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. 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.

See our latest analysis for Topps Tiles

The Model

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. 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.

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£10.1m	UK£5.65m	UK£7.95m	UK£9.70m	UK£12.6m	UK£14.8m	UK£16.6m	UK£18.2m	UK£19.5m	UK£20.5m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Est @ 17.24%	Est @ 12.60%	Est @ 9.35%	Est @ 7.08%	Est @ 5.49%
Present Value (£, Millions) Discounted @ 10%	UK£9.1	UK£4.6	UK£5.9	UK£6.5	UK£7.7	UK£8.1	UK£8.3	UK£8.2	UK£7.9	UK£7.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£74m

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 (1.8%) 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 10%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£21m× (1 + 1.8%) ÷ (10%– 1.8%) = UK£240m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£240m÷ ( 1 + 10%)¹⁰= UK£88m

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£162m. 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£0.4, the company appears quite undervalued at a 47% 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

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. 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 Topps Tiles 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 10%, which is based on a levered beta of 1.592. 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 Topps Tiles

Strength

• Currently debt free.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

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

• Good value based on P/S ratio and estimated fair value.

Threat

• Dividends are not covered by earnings.

• Revenue is forecast to grow slower than 20% per year.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price sitting below the intrinsic value? For Topps Tiles, we've put together three pertinent elements you should look at:

1. Risks: For example, we've discovered 2 warning signs for Topps Tiles that you should be aware of before investing here.

2. Future Earnings: How does TPT'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 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.

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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.