A Look At The Fair Value Of ImpediMed Limited (ASX:IPD)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ImpediMed Limited (ASX:IPD) as an investment opportunity 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. There's really not all that much to it, even though it might appear quite complex.

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 ImpediMed

Crunching the numbers

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.

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) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (A$, Millions)	-AU$16.0m	-AU$9.00m	AU$6.40m	AU$9.26m	AU$12.2m	AU$15.0m	AU$17.5m	AU$19.6m	AU$21.4m	AU$22.9m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 44.73%	Est @ 31.87%	Est @ 22.87%	Est @ 16.56%	Est @ 12.15%	Est @ 9.07%	Est @ 6.9%
Present Value (A$, Millions) Discounted @ 5.7%	-AU$15.1	-AU$8.1	AU$5.4	AU$7.4	AU$9.2	AU$10.7	AU$11.8	AU$12.6	AU$13.0	AU$13.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$60m

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. 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.7%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$23m× (1 + 1.9%) ÷ (5.7%– 1.9%) = AU$602m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$602m÷ ( 1 + 5.7%)¹⁰= AU$345m

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$405m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.2, the company appears about fair value at a 17% 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

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. 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 ImpediMed 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 5.7%, which is based on a levered beta of 0.883. 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.

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. For ImpediMed, we've put together three additional aspects you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with ImpediMed , and understanding this should be part of your investment process.
2. Future Earnings: How does IPD'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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.