Mercia Asset Management PLC

LSE:MERC

Discounted Cash Flow (DCF) valuation is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money.

DCF valuation is one of two methods of placing a monetary value on a company; the other is Relative Valuation method. We use a combination of these two methods to calculate the Intrinsic Value of stock as accurately as possible.

Alpha Spread forecasts a company's future cash flow and estimates the appropriate discount rate to calculate the DCF value of a stock.

1. Free cash flow forecasting

You can view the operating model used to estimate free cash flow in the "DCF Operating Model" block. You can change model inputs forecasted by our algorithm (such as revenue growth, margins, etc.) if you are a professional analyst and have your own opinion about them.
Click here to read more about FCF forecasting.

2. Calculating present value

Once free cash flow is forecasted, it is discounted at a risk-appropriate discount rate (which you can also change in the DCF settings). The resulting value is the present value of the company's free cash flow.

DCF Operating Model

Capital Structure

3. Calculating the value of equity

Depending on which type of operating model for the company our algorithm has chosen (equity or whole firm valuation model), the resulting value is either the value of equity or the value of the entire firm. In the case of the latter, to move from the value of the firm to the value of equity, liabilities are subtracted and assets are added. You can see these and subsequent steps in the block "Capital structure".

4. Calculating the DCF value of one stock

In order to come from the value of equity to the DCF value of one share, we only need divide the equity value by the number of shares outstanding.

A stock has no absolute intrinsic value because the future is not predetermined.

We build several DCF models for different scenarios of the company's future so you can see a complete picture of the investment risks and opportunities.

Relative valuation is used to value companies by comparing them to other businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E ratios.

Relative valuation is one of two methods of placing a monetary value on a company; the other is Discounted Cash Flow valuation method. We use a combination of these two methods to calculate the Intrinsic Value of stock as accurately as possible.

Our algorithm takes into account all the information about the company's valuation multiples (their historical values, how competitors are priced, and much more) and consolidates it into one single number - relative value.

Backtesting is a powerful tool that simulates how a particular strategy or model would have performed on historical data. This process allows investors to evaluate the effectiveness of investment decisions based on past market data without risking actual capital.

1. Select Valuation Methods: Choose the valuation methods you believe best represent the true value of the stocks you're interested in.

2. Define Trading Criteria: Specify the buy/sell conditions based on the stock's valuation relative to its market price.

3. Run the Backtest: Initiate the process to see how your strategy would have performed historically.

4. Analyze Results: Review the outcomes to refine your investment strategies and improve future decision-making.

By leveraging historical data, backtesting provides a window into how investment strategies might perform under similar market conditions, offering invaluable insights for future investments.

Note: Past results don't guarantee future performance.

Free Cash Flow (FCF) is the money a company has left over after it pays for all its expenses and any investments it needs to make to keep the company running smoothly.

Think of it like your personal budget at home: after you pay for your necessities, like rent and groceries, and set aside money for future needs, like saving for a car or home repairs, the cash you have left is what you're free to spend or save as you wish.

It's a sign of a company's health and its ability to do things like grow its business, pay dividends to shareholders, or reduce debt.

Flexibility: Companies with more FCF can make big moves without having to borrow money or ask for more investment, giving them the freedom to grow or tackle new projects on their terms.

Rewards for Investors: When a company has extra cash, it can decide to give some back to its investors through dividends or by buying back shares, which can increase the value of the remaining shares.

A Healthy Sign: Regularly having more cash coming in than going out shows that a company is doing well, making smart decisions, and earning more than it spends.

Shareholder Yield is an integrated metric that represents the total returns a company delivers to its shareholders, including dividends, share buybacks, and debt reduction. It offers a holistic view of a company's capital return strategies, going beyond simple dividend yields to encompass all forms of shareholder returns.

The calculation of Shareholder Yield involves summing the dividend yield, buyback yield, and debt paydown yield:

• Dividend Yield is calculated by dividing the annual dividends per share by the stock price per share.

• Buyback Yield reflects the decrease in shares outstanding, showing how much a company is investing in repurchasing its shares.

• Debt Paydown Yield measures the reduction of debt in relation to the company’s market capitalization, highlighting efforts to reduce financial liabilities.

High Shareholder Yield is often associated with superior long-term performance in the stock market, making it a crucial measure for investors seeking stocks that consistently deliver high returns through dividends, buybacks, and effective debt management. This metric highlights the importance of looking beyond traditional dividend yields to consider how companies return capital to shareholders in other ways, enhancing overall investment analysis.

Buyback Yield measures how much a company reduces its outstanding shares through repurchases, expressed as a percentage. It is calculated by taking the decrease in shares outstanding during a period, dividing it by the total shares at the beginning of that period, and then converting this figure into a percentage.

This metric is crucial for calculating Shareholder Yield as it directly reflects the company’s efforts to return value to shareholders. By reducing the number of shares, buybacks can increase earnings per share and potentially boost the stock's price. Including Buyback Yield provides a fuller understanding of how capital is used to enhance shareholder returns, alongside dividends and debt reduction.

Debt Paydown Yield measures the amount of debt a company repays within a specific period, shown as a percentage of its market capitalization. It is calculated by taking the reduction in total debt from the beginning to the end of the period, dividing this amount by the company's market capitalization at the start of the period, and then expressing the result as a percentage.

This metric is important for calculating Shareholder Yield because it indicates how the company is using its capital to decrease financial liabilities, which can strengthen its financial health and potentially enhance shareholder value. Including Debt Paydown Yield in the Shareholder Yield calculation gives investors insight into the company's commitment to reducing debt alongside returning value through dividends and buybacks.

Current vs Historical Average shows the difference between a stock's current undervaluation or overvaluation and its average over the past five years.

A larger gap means a greater potential for profit if the stock returns to its typical valuation.

Dividend Safety Rate is a comprehensive numerical rating that helps investors evaluate the risk associated with a company’s dividend payments. Ranging from 0 to 100, the rate provides an assessment where higher values denote greater security and lower likelihood of a dividend cut. This measure is particularly valuable for income-focused investors as it synthesizes key financial indicators including payout ratios, dividend history, and the overall financial health of the company.

By incorporating both dividend performance and broader financial metrics, the Dividend Safety Rate offers a holistic view of a company’s ability to maintain and potentially increase its dividend payments.

In calculating the Dividend Safety Rate, we consider a variety of financial metrics:

Multiple Payout Ratios: These include the current payout ratio and average historical payout ratios, which help assess how comfortably a company can cover its dividend payments with its earnings.

Dividend Growth Streak: The number of consecutive years a company has increased its dividend, indicating reliability and stability in its dividend policy.

Solvency and Profitability Ratios: These ratios evaluate a company’s ability to meet its long-term obligations and its overall financial health, which are crucial for sustaining dividend payments over time.