Today we are going to review one way to estimate the intrinsic value of LPP SA (WSE: LPP) by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too hard to follow, as you will see in our example!

Keep in mind, however, that there are many ways to estimate the value of a business, and a DCF is just one method. Anyone interested in knowing a little more about intrinsic value should read the Simply Wall St analysis model.

See our latest analysis for LPP

### Step by step in the calculation

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

Generally, we assume that a dollar today is worth more 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) estimate

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Leverage FCF (PLN, Millions) zÅ‚273.9m zÅ‚764.0m zÅ‚1.10b zÅ‚1.44b zÅ‚1.57b zÅ‚1.67b zÅ‚1.76b zÅ‚1.84b zÅ‚1.91b zÅ‚1.98b Source of growth rate estimate Analyst x4 Analyst x6 Analyst x6 Analyst x5 Analyst x5 Est @ 6.46% East @ 5.27% East @ 4.43% Est @ 3.85% East @ 3.44% Present value (PLN, millions) discounted at 8.2% zÅ‚253 zÅ‚653 zÅ‚872 zÅ‚1.1k zÅ‚1.1k zÅ‚1.0k zÅ‚1.0k zÅ‚982 zÅ‚943 zÅ‚902

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = zÅ‚8.8b

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.5%) to estimate future growth. Similar to the 10-year â€œgrowthâ€ period, we discount future cash flows to their present value, using a cost of equity of 8.2%.

Terminal value (TV)= FCF2031 Ã— (1 + g) Ã· (r – g) = zÅ‚2.0b Ã— (1 + 2.5%) Ã· (8.2% – 2.5%) = zÅ‚36b

Present value of terminal value (PVTV)= TV / (1 + r)ten= zÅ‚36b Ã· (1 + 8.2%)ten= zÅ‚16b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is zÅ‚25b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of Z14,000, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

### Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we consider LPP 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 takes debt into account. In this calculation, we used 8.2%, which is based on a leveraged beta of 1.115. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

### Next steps:

While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For LPP, we have compiled three additional aspects that you need to assess:

1. Financial health: Does LPP 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.
2. Future benefits: How does LPP’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!

PS. Simply Wall St updates its DCF calculation for every Polish stock every day, so if you want to find the intrinsic value of any other stock just search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.

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