Key Insights

Using the 2 Stage Free Cash Flow to Equity, Premier Foods fair value estimate is UK£1.70 Current share price of UK£1.30 suggests Premier Foods is potentially 23% undervalued Analyst price target for PFD is UK£1.63 which is 3.9% below our fair value estimate

Does the July share price for Premier Foods plc (LON:PFD) 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. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

Check out our latest analysis for Premier Foods

The Model

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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£75.0m UK£87.1m UK£86.7m UK£86.8m UK£87.1m UK£87.7m UK£88.5m UK£89.3m UK£90.2m UK£91.2m Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Est @ 0.08% Est @ 0.42% Est @ 0.67% Est @ 0.84% Est @ 0.96% Est @ 1.04% Est @ 1.10% Present Value (£, Millions) Discounted @ 6.8%  UK£70.2 UK£76.3 UK£71.1 UK£66.7 UK£62.7 UK£59.1 UK£55.8 UK£52.7 UK£49.8 UK£47.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£611m



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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£91m× (1 + 1.2%) ÷ (6.8%– 1.2%) = UK£1.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.7b÷ ( 1 + 6.8%)10= UK£857m

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£1.5b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.3, the company appears a touch undervalued at a 23% 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. 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. 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 Premier Foods 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 0.800. 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 Premier Foods

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 Food 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.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Premier Foods, there are three fundamental elements you should consider:

Financial Health: Does PFD 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 PFD'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. 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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