Is There An Opportunity With Nova Eye Medical Limited's (ASX:EYE) 43% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Nova Eye Medical fair value estimate is AU$0.40
• Nova Eye Medical's AU$0.23 share price signals that it might be 43% undervalued
• The average premium for Nova Eye Medical's competitorsis currently 69%

Today we will run through one way of estimating the intrinsic value of Nova Eye Medical Limited (ASX:EYE) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Nova Eye Medical

Is Nova Eye Medical Fairly Valued?

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 start off with, we need to estimate 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	-AU$8.40m	-AU$2.10m	AU$1.20m	AU$1.93m	AU$2.77m	AU$3.63m	AU$4.44m	AU$5.16m	AU$5.78m	AU$6.30m
Growth Rate Estimate Source	Analyst x1	Analyst x2	Analyst x2	Est @ 60.97%	Est @ 43.33%	Est @ 30.98%	Est @ 22.33%	Est @ 16.28%	Est @ 12.04%	Est @ 9.08%
Present Value (A$, Millions) Discounted @ 6.4%	-AU$7.9	-AU$1.9	AU$1.0	AU$1.5	AU$2.0	AU$2.5	AU$2.9	AU$3.1	AU$3.3	AU$3.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$10.0m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$6.3m× (1 + 2.2%) ÷ (6.4%– 2.2%) = AU$152m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$152m÷ ( 1 + 6.4%)¹⁰= AU$82m

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$92m. 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$0.2, the company appears quite good value at a 43% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Nova Eye Medical 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 6.4%, which is based on a levered beta of 0.922. 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 Nova Eye Medical

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price sitting below the intrinsic value? For Nova Eye Medical, we've compiled three relevant aspects you should look at:

1. Risks: We feel that you should assess the 3 warning signs for Nova Eye Medical (1 is a bit concerning!) we've flagged before making an investment in the company.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for EYE's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. 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. 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.