Stock Analysis

# Enghouse Systems Limited (TSE:ENGH) Shares Could Be 43% Below Their Intrinsic Value Estimate

Today we will run through one way of estimating the intrinsic value of Enghouse Systems Limited (TSE:ENGH) 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. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Enghouse Systems

### Step by step through the calculation

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. 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) forecast

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Levered FCF (CA\$, Millions) CA\$115.7m CA\$156.5m CA\$154.4m CA\$153.8m CA\$154.0m CA\$154.9m CA\$156.2m CA\$157.9m CA\$159.8m CA\$161.9m Growth Rate Estimate Source Analyst x2 Analyst x2 Est @ -1.31% Est @ -0.45% Est @ 0.15% Est @ 0.58% Est @ 0.87% Est @ 1.08% Est @ 1.22% Est @ 1.32% Present Value (CA\$, Millions) Discounted @ 5.8% CA\$109 CA\$140 CA\$130 CA\$123 CA\$116 CA\$110 CA\$105 CA\$100 CA\$95.9 CA\$91.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA\$1.1b

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 (1.6%) 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 5.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA\$162m× (1 + 1.6%) ÷ (5.8%– 1.6%) = CA\$3.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA\$3.8b÷ ( 1 + 5.8%)10= CA\$2.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA\$3.3b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA\$33.9, the company appears quite undervalued 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.

### The assumptions

Now 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 Enghouse Systems 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 5.8%, which is based on a levered beta of 1.011. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Enghouse Systems, we've compiled three pertinent elements you should explore:

1. Risks: We feel that you should assess the 1 warning sign for Enghouse Systems we've flagged before making an investment in the company.
2. Future Earnings: How does ENGH'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 TSX every day. If you want to find the calculation for other stocks just search here.

### Valuation is complex, but we're here to simplify it.

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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.