Is There An Opportunity With Velocity Composites plc's (LON:VEL) 34% Undervaluation?

Key Insights

• Velocity Composites' estimated fair value is UK£0.48 based on 2 Stage Free Cash Flow to Equity
• Current share price of UK£0.32 suggests Velocity Composites is potentially 34% undervalued
• Velocity Composites' peers seem to be trading at a lower discount to fair value based onthe industry average of 32%

How far off is Velocity Composites plc (LON:VEL) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 Velocity Composites

The Method

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 start off with, we need to estimate 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£1.20m	UK£1.20m	UK£1.21m	UK£1.22m	UK£1.23m	UK£1.24m	UK£1.26m	UK£1.28m	UK£1.30m	UK£1.32m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 0.49%	Est @ 0.84%	Est @ 1.08%	Est @ 1.25%	Est @ 1.36%	Est @ 1.45%	Est @ 1.50%	Est @ 1.55%
Present Value (£, Millions) Discounted @ 6.1%	UK£1.1	UK£1.1	UK£1.0	UK£1.0	UK£0.9	UK£0.9	UK£0.8	UK£0.8	UK£0.8	UK£0.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£9.1m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 6.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£1.3m× (1 + 1.6%) ÷ (6.1%– 1.6%) = UK£30m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£30m÷ ( 1 + 6.1%)¹⁰= UK£17m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£26m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.3, the company appears quite good value at a 34% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Velocity Composites 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 6.1%, which is based on a levered beta of 0.817. 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.

SWOT Analysis for Velocity Composites

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Velocity Composites, there are three essential aspects you should explore:

1. Risks: Every company has them, and we've spotted 3 warning signs for Velocity Composites you should know about.
2. Future Earnings: How does VEL'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. Simply Wall St updates its DCF calculation for every British 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. 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.