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WPP plc (LON:WPP) Shares Could Be 45% Below Their Intrinsic Value Estimate

Key Insights

  • WPP's estimated fair value is UK£14.01 based on 2 Stage Free Cash Flow to Equity

  • Current share price of UK£7.72 suggests WPP is potentially 45% undervalued

  • Our fair value estimate is 59% higher than WPP's analyst price target of UK£8.84

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of WPP plc (LON:WPP) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

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See our latest analysis for WPP

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (£, Millions)

UK£977.9m

UK£1.14b

UK£1.24b

UK£855.0m

UK£1.15b

UK£1.13b

UK£1.13b

UK£1.13b

UK£1.13b

UK£1.14b

Growth Rate Estimate Source

Analyst x4

Analyst x5

Analyst x5

Analyst x1

Analyst x1

Est @ -1.67%

Est @ -0.64%

Est @ 0.09%

Est @ 0.59%

Est @ 0.94%

Present Value (£, Millions) Discounted @ 8.4%

UK£902

UK£970

UK£972

UK£619

UK£770

UK£698

UK£640

UK£591

UK£548

UK£510

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£7.2b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£1.1b× (1 + 1.8%) ÷ (8.4%– 1.8%) = UK£18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£18b÷ ( 1 + 8.4%)10= UK£7.8b

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£15b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£7.7, the company appears quite undervalued at a 45% 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
dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 WPP 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 8.4%, which is based on a levered beta of 1.213. 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 WPP

Strength

  • Debt is well covered by cash flow.

Weakness

  • Earnings declined over the past year.

  • Interest payments on debt are not well covered.

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

Opportunity

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

  • Trading below our estimate of fair value by more than 20%.

Threat

  • Dividends are not covered by earnings.

  • Annual revenue is expected to decline over the next 3 years.

Moving On:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Why is the intrinsic value higher than the current share price? For WPP, there are three additional elements you should further research:

  1. Risks: You should be aware of the 3 warning signs for WPP (1 is potentially serious!) we've uncovered before considering an investment in the company.

  2. Future Earnings: How does WPP'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock 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.