Stock Analysis

An Intrinsic Calculation For Water Intelligence plc (LON:WATR) Suggests It's 22% Undervalued

  •  Updated
AIM:WATR
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Does the October share price for Water Intelligence plc (LON:WATR) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Our analysis indicates that WATR is potentially undervalued!

What's The Estimated Valuation?

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. 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

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$6.50m US$7.10m US$7.52m US$7.86m US$8.13m US$8.35m US$8.53m US$8.69m US$8.82m US$8.95m
Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ 5.97% Est @ 4.47% Est @ 3.43% Est @ 2.7% Est @ 2.19% Est @ 1.83% Est @ 1.58% Est @ 1.4%
Present Value ($, Millions) Discounted @ 6.1% US$6.1 US$6.3 US$6.3 US$6.2 US$6.0 US$5.9 US$5.6 US$5.4 US$5.2 US$5.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$58m

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 (1.0%) 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)= FCF2032 × (1 + g) ÷ (r – g) = US$8.9m× (1 + 1.0%) ÷ (6.1%– 1.0%) = US$177m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$177m÷ ( 1 + 6.1%)10= US$98m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$156m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£6.2, the company appears a touch undervalued at a 22% 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.

dcf
AIM:WATR Discounted Cash Flow October 25th 2022

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Water Intelligence 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 0.956. 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 Water Intelligence

Strength
  • Debt is not viewed as a risk.
Weakness
  • Earnings declined over the past year.
  • Shareholders have been diluted in the past year.
Opportunity
  • Annual earnings are forecast to grow faster than the British market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Revenue is forecast to grow slower than 20% per year.

Next Steps:

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. 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Water Intelligence, we've put together three fundamental items you should assess:

  1. Risks: Every company has them, and we've spotted 2 warning signs for Water Intelligence you should know about.
  2. Future Earnings: How does WATR'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 AIM every day. If you want to find the calculation for other stocks just search here.

Valuation is complex, but we're helping make it simple.

Find out whether Water Intelligence is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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