Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Efecte Oy (HEL:EFECTE) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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.
View our latest analysis for Efecte Oy
Step by step through the calculation
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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF (€, Millions) | -€300.0k | €1.20m | €2.00m | €2.50m | €2.86m | €3.15m | €3.38m | €3.55m | €3.68m | €3.77m |
Growth Rate Estimate Source | Analyst x1 | Analyst x1 | Analyst x1 | Analyst x1 | Est @ 14.36% | Est @ 10.14% | Est @ 7.18% | Est @ 5.11% | Est @ 3.66% | Est @ 2.65% |
Present Value (€, Millions) Discounted @ 5.9% | -€0.3 | €1.1 | €1.7 | €2.0 | €2.1 | €2.2 | €2.3 | €2.2 | €2.2 | €2.1 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €17m
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 0.3%. We discount the terminal cash flows to today's value at a cost of equity of 5.9%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = €3.8m× (1 + 0.3%) ÷ (5.9%– 0.3%) = €68m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €68m÷ ( 1 + 5.9%)10= €38m
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 €55m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €10.8, the company appears around fair value at the time of writing. 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. 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 Efecte Oy 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 5.9%, which is based on a levered beta of 0.964. 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 ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 Efecte Oy, we've put together three further factors you should look at:
- Risks: Case in point, we've spotted 2 warning signs for Efecte Oy you should be aware of.
- Future Earnings: How does EFECTE'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: 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 HLSE every day. If you want to find the calculation for other stocks just search here.
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About HLSE:EFECTE
Efecte Oy
A software company, provides cloud-based service management solutions in Finland and internationally.
High growth potential with mediocre balance sheet.