Key Insights

Keystone Law Group's estimated fair value is UK£4.41 based on 2 Stage Free Cash Flow to Equity Keystone Law Group's UK£4.47 share price indicates it is trading at similar levels as its fair value estimate The UK£7.98 analyst price target for KEYS is 81% more than our estimate of fair value

Does the May share price for Keystone Law Group plc (LON:KEYS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Keystone Law Group

Crunching The Numbers

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 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

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (£, Millions)  UK£6.82m UK£6.78m UK£7.48m UK£8.31m UK£8.52m UK£8.95m UK£9.27m UK£9.53m UK£9.75m UK£9.95m Growth Rate Estimate Source Analyst x3 Analyst x4 Analyst x4 Analyst x3 Analyst x1 Analyst x1 Est @ 3.52% Est @ 2.84% Est @ 2.36% Est @ 2.02% Present Value (£, Millions) Discounted @ 7.4%  UK£6.4 UK£5.9 UK£6.0 UK£6.3 UK£6.0 UK£5.8 UK£5.6 UK£5.4 UK£5.1 UK£4.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£57m

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. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£9.9m× (1 + 1.2%) ÷ (7.4%– 1.2%) = UK£165m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£165m÷ ( 1 + 7.4%)10= UK£81m

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£138m. 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£4.5, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out. 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 Keystone Law 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 7.4%, which is based on a levered beta of 0.878. 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 Keystone Law Group

Strength

Currently debt free.

Dividends are covered by earnings and cash flows.

Weakness

Earnings growth over the past year underperformed the Professional Services industry.

Dividend is low compared to the top 25% of dividend payers in the Professional Services market.

Expensive based on P/E ratio and estimated fair value.

Opportunity

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

Threat

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

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. For Keystone Law Group, we've put together three essential elements you should further examine:

Risks: You should be aware of the 1 warning sign for Keystone Law Group we've uncovered before considering an investment in the company. Future Earnings: How does KEYS'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 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. 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.

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