Estimating The Fair Value Of Technology One Limited (ASX:TNE)

Does the July share price for Technology One Limited (ASX:TNE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present 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.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Technology One

The model

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (A$, Millions)	AU$67.0m	AU$82.6m	AU$101.0m	AU$127.0m	AU$146.4m	AU$162.9m	AU$176.7m	AU$188.2m	AU$197.8m	AU$206.0m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Analyst x1	Est @ 15.27%	Est @ 11.27%	Est @ 8.46%	Est @ 6.5%	Est @ 5.13%	Est @ 4.16%
Present Value (A$, Millions) Discounted @ 6.4%	AU$63.0	AU$72.9	AU$83.9	AU$99.1	AU$107	AU$112	AU$114	AU$115	AU$113	AU$111

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$991m

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 (1.9%) 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 6.4%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$206m× (1 + 1.9%) ÷ (6.4%– 1.9%) = AU$4.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$4.7b÷ ( 1 + 6.4%)¹⁰= AU$2.5b

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$3.5b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$9.3, the company appears about fair value at a 15% 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

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. 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 Technology One 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 0.948. 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 shouldn't be the only metric you look at when researching 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Technology One, we've put together three further factors you should further examine:

1. Risks: Take risks, for example - Technology One has 2 warning signs (and 1 which is significant) we think you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for TNE'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. 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. 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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