British American Tobacco p.l.c.'s (LON:BATS) Intrinsic Value Is Potentially 98% Above Its Share Price

In this article we are going to estimate the intrinsic value of British American Tobacco p.l.c. (LON:BATS) by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for British American Tobacco

Is British American Tobacco 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. 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (£, Millions)	UK£8.08b	UK£8.35b	UK£8.40b	UK£7.28b	UK£7.15b	UK£7.09b	UK£7.08b	UK£7.09b	UK£7.13b	UK£7.18b
Growth Rate Estimate Source	Analyst x9	Analyst x7	Analyst x2	Analyst x1	Est @ -1.71%	Est @ -0.83%	Est @ -0.21%	Est @ 0.22%	Est @ 0.52%	Est @ 0.73%
Present Value (£, Millions) Discounted @ 6.8%	UK£7.6k	UK£7.3k	UK£6.9k	UK£5.6k	UK£5.2k	UK£4.8k	UK£4.5k	UK£4.2k	UK£4.0k	UK£3.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£54b

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)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK£7.2b× (1 + 1.2%) ÷ (6.8%– 1.2%) = UK£131b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£131b÷ ( 1 + 6.8%)¹⁰= UK£68b

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£122b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£26.9, the company appears quite undervalued at a 50% 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

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 British American Tobacco 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For British American Tobacco, there are three further elements you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with British American Tobacco , and understanding them should be part of your investment process.

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

3. 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.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.