In this article we are going to estimate the intrinsic value of IPH Limited (ASX:IPH) by projecting its future cash flows and then discounting them to today's value. This will be done using 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 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 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.
Crunching the numbers
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. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (A$, Millions)||AU$81.0m||AU$84.5m||AU$90.7m||AU$90.4m||AU$90.8m||AU$91.6m||AU$92.7m||AU$94.0m||AU$95.6m||AU$97.2m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Analyst x2||Est @ -0.3%||Est @ 0.39%||Est @ 0.88%||Est @ 1.22%||Est @ 1.45%||Est @ 1.62%||Est @ 1.74%|
|Present Value (A$, Millions) Discounted @ 7.0%||AU$75.7||AU$73.8||AU$74.1||AU$69.0||AU$64.8||AU$61.1||AU$57.8||AU$54.8||AU$52.0||AU$49.5|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$632m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 (2.0%) 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 7.0%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU$97m× (1 + 2.0%) ÷ (7.0%– 2.0%) = AU$2.0b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$2.0b÷ ( 1 + 7.0%)10= AU$1.0b
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$1.6b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$7.0, the company appears about fair value at a 8.2% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 IPH 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 7.0%, which is based on a levered beta of 0.951. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For IPH, there are three relevant factors you should look at:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with IPH , and understanding it should be part of your investment process.
- Future Earnings: How does IPH'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.
- 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 ASX 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. 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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