An Intrinsic Calculation For Electro Optic Systems Holdings Limited (ASX:EOS) Suggests It's 35% Undervalued

Key Insights

• The projected fair value for Electro Optic Systems Holdings is AU$1.61 based on 2 Stage Free Cash Flow to Equity
• Electro Optic Systems Holdings is estimated to be 35% undervalued based on current share price of AU$1.05
• Our fair value estimate is 21% higher than Electro Optic Systems Holdings' analyst price target of AU$1.34

In this article we are going to estimate the intrinsic value of Electro Optic Systems Holdings Limited (ASX:EOS) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

Check out our latest analysis for Electro Optic Systems Holdings

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$25.7m	AU$17.2m	AU$16.0m	AU$17.7m	AU$16.2m	AU$15.3m	AU$14.8m	AU$14.6m	AU$14.5m	AU$14.5m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Analyst x1	Est @ -8.65%	Est @ -5.45%	Est @ -3.21%	Est @ -1.65%	Est @ -0.55%	Est @ 0.22%
Present Value (A$, Millions) Discounted @ 6.9%	AU$24.1	AU$15.1	AU$13.1	AU$13.6	AU$11.6	AU$10.2	AU$9.3	AU$8.5	AU$7.9	AU$7.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$121m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.0%) 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 6.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$15m× (1 + 2.0%) ÷ (6.9%– 2.0%) = AU$303m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$303m÷ ( 1 + 6.9%)¹⁰= AU$156m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$277m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$1.1, the company appears quite undervalued at a 35% 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.

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 Electro Optic Systems Holdings 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 6.9%, which is based on a levered beta of 0.976. 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.

SWOT Analysis for Electro Optic Systems Holdings

Moving On:

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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Electro Optic Systems Holdings, we've put together three fundamental factors you should further examine:

1. Risks: You should be aware of the 2 warning signs for Electro Optic Systems Holdings we've uncovered before considering an investment in the company.
2. Future Earnings: How does EOS's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. 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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock 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.