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In this article I am going to calculate the intrinsic value of Photon Control Inc. (TSE:PHO) by taking the expected future cash flows and discounting them to today’s value. This is done using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in February 2019 so be sure check out the updated calculation by following the link below.
Is PHO fairly valued?
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow forecast
|Levered FCF (CA$, Millions)||CA$11.45||CA$14.00||CA$16.52||CA$19.33||CA$22.42|
|Source||Analyst x2||Analyst x1||Est @ 18%, capped from 22.51%||Est @ 17%, capped from 22.51%||Est @ 16%, capped from 22.51%|
|Present Value Discounted @ 8.39%||CA$10.56||CA$11.92||CA$12.97||CA$14.00||CA$14.99|
Present Value of 5-year Cash Flow (PVCF)= CA$64m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (1.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = CA$22m × (1 + 1.9%) ÷ (8.4% – 1.9%) = CA$355m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CA$355m ÷ ( 1 + 8.4%)5 = CA$237m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CA$302m. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of CA$2.75. Compared to the current share price of CA$1.47, the stock is quite undervalued at a 46% discount to what it is available for right now.
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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Photon Control as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For PHO, I’ve put together three key factors you should look at:
- Financial Health: Does PHO have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does PHO’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of PHO? 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 for every stock on the TSE every 6 hours. If you want to find the calculation for other stocks just search here.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.