Diageo plc's (LON:DGE) Intrinsic Value Is Potentially 28% Above Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Diageo fair value estimate is UK£44.92

• Diageo is estimated to be 22% undervalued based on current share price of UK£34.98

• Analyst price target for DGE is UK£39.77 which is 11% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Diageo plc (LON:DGE) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Diageo

Is Diageo Fairly Valued?

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£2.57b	UK£3.35b	UK£3.69b	UK£4.35b	UK£5.17b	UK£5.73b	UK£6.18b	UK£6.54b	UK£6.84b	UK£7.08b
Growth Rate Estimate Source	Analyst x10	Analyst x10	Analyst x10	Analyst x3	Analyst x1	Est @ 10.75%	Est @ 7.89%	Est @ 5.90%	Est @ 4.50%	Est @ 3.52%
Present Value (£, Millions) Discounted @ 6.8%	UK£2.4k	UK£2.9k	UK£3.0k	UK£3.3k	UK£3.7k	UK£3.9k	UK£3.9k	UK£3.9k	UK£3.8k	UK£3.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£34b

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

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£7.1b× (1 + 1.2%) ÷ (6.8%– 1.2%) = UK£129b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£129b÷ ( 1 + 6.8%)¹⁰= UK£66b

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£101b. 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£35.0, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Diageo 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 Diageo

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings.

• Dividends are covered by earnings and cash flows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Beverage 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

• Debt is not well covered by operating cash flow.

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

Looking Ahead:

Although the valuation of a company is important, it 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Diageo, we've compiled three fundamental elements you should consider:

1. Risks: Be aware that Diageo is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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

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.

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