Is There An Opportunity With Enero Group Limited's (ASX:EGG) 34% Undervaluation?

Today we will run through one way of estimating the intrinsic value of Enero Group Limited (ASX:EGG) 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. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Enero Group

The model

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, 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (A$, Millions)	AU$20.9m	AU$24.7m	AU$21.8m	AU$20.2m	AU$19.3m	AU$18.7m	AU$18.5m	AU$18.5m	AU$18.5m	AU$18.7m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -7.43%	Est @ -4.6%	Est @ -2.62%	Est @ -1.23%	Est @ -0.26%	Est @ 0.42%	Est @ 0.9%
Present Value (A$, Millions) Discounted @ 6.7%	AU$19.6	AU$21.7	AU$17.9	AU$15.5	AU$13.9	AU$12.7	AU$11.7	AU$11.0	AU$10.3	AU$9.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$144m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.7%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = AU$19m× (1 + 2.0%) ÷ (6.7%– 2.0%) = AU$403m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$403m÷ ( 1 + 6.7%)¹⁰= AU$210m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$354m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.7, the company appears quite undervalued at a 34% 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

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 Enero Group 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 6.7%, which is based on a levered beta of 0.905. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Enero Group, we've put together three pertinent items you should further research:

1. Risks: Take risks, for example - Enero Group has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
2. Future Earnings: How does EGG'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. 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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