Key Insights

Capita's estimated fair value is UK£0.41 based on 2 Stage Free Cash Flow to Equity Capita's UK£0.21 share price signals that it might be 49% undervalued Our fair value estimate is 7.2% higher than Capita's analyst price target of UK£0.38

How far off is Capita plc (LON:CPI) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

Check out our latest analysis for Capita

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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£27.9m UK£25.7m UK£40.2m UK£56.3m UK£72.3m UK£87.0m UK£99.8m UK£110.6m UK£119.4m UK£126.6m Growth Rate Estimate Source Analyst x3 Analyst x3 Est @ 56.53% Est @ 40.03% Est @ 28.47% Est @ 20.39% Est @ 14.73% Est @ 10.77% Est @ 7.99% Est @ 6.05% Present Value (£, Millions) Discounted @ 12%  -UK£24.8 UK£20.4 UK£28.4 UK£35.4 UK£40.6 UK£43.5 UK£44.5 UK£43.9 UK£42.2 UK£39.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£314m



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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£127m× (1 + 1.5%) ÷ (12%– 1.5%) = UK£1.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£1.2b÷ ( 1 + 12%)10= UK£378m

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£692m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.2, the company appears quite undervalued at a 49% 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

We would point out that 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 Capita 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 12%, which is based on a levered beta of 1.814. 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 is only one of many factors that you need to assess 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. What is the reason for the share price sitting below the intrinsic value? For Capita, we've compiled three essential items you should assess:

Risks: To that end, you should be aware of the  1 warning sign  we've spotted with Capita . Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CPI's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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. 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.

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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.