Key Insights

Imperial Brands' estimated fair value is UK£57.01 based on 2 Stage Free Cash Flow to Equity Current share price of UK£28.65 suggests Imperial Brands is potentially 50% undervalued Analyst price target for IMB is UK£29.89 which is 48% below our fair value estimate

How far off is Imperial Brands PLC (LON:IMB) 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. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 Levered FCF (£, Millions)  UK£2.85b UK£2.93b UK£3.01b UK£2.96b UK£2.67b UK£2.64b UK£2.64b UK£2.65b UK£2.68b UK£2.72b Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x4 Analyst x1 Analyst x1 Est @ -1.26% Est @ -0.19% Est @ 0.56% Est @ 1.08% Est @ 1.45% Present Value (£, Millions) Discounted @ 7.3%  UK£2.7k UK£2.5k UK£2.4k UK£2.2k UK£1.9k UK£1.7k UK£1.6k UK£1.5k UK£1.4k UK£1.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£19b

Story Continues

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.3%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = UK£2.7b× (1 + 2.3%) ÷ (7.3%– 2.3%) = UK£55b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£55b÷ ( 1 + 7.3%)10= UK£27b

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£47b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£28.7, the company appears quite undervalued at a 50% 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.LSE:IMB Discounted Cash Flow April 1st 2025

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Imperial Brands 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 7.3%, which is based on a levered beta of 0.977. 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.

View our latest analysis for Imperial Brands

SWOT Analysis for Imperial Brands

Strength

Earnings growth over the past year exceeded the industry.

Debt is well covered by earnings and cashflows.

Dividends are covered by earnings and cash flows.

Weakness

Dividend is low compared to the top 25% of dividend payers in the Tobacco market.

Opportunity

Good value based on P/E ratio and estimated fair value.

Threat

Annual earnings are forecast to decline for the next 3 years.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Imperial Brands, we've put together three relevant aspects you should explore:

Risks: Consider for instance, the ever-present spectre of investment risk.  We've identified 3 warning signs  with Imperial Brands (at least 1 which is concerning)  , and understanding these should be part of your investment process. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for IMB's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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.

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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.

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