Water Intelligence plc's (LON:WATR) Intrinsic Value Is Potentially 35% Above Its Share Price

Key Insights

• The projected fair value for Water Intelligence is UK£5.63 based on 2 Stage Free Cash Flow to Equity
• Water Intelligence's UK£4.18 share price signals that it might be 26% undervalued
• Analyst price target for WATR is US$12.38, which is 120% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of Water Intelligence plc (LON:WATR) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

See our latest analysis for Water Intelligence

The Model

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. 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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$6.20m	US$7.00m	US$7.57m	US$8.03m	US$8.39m	US$8.69m	US$8.94m	US$9.14m	US$9.32m	US$9.49m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 8.13%	Est @ 6.04%	Est @ 4.57%	Est @ 3.55%	Est @ 2.83%	Est @ 2.32%	Est @ 1.97%	Est @ 1.73%
Present Value ($, Millions) Discounted @ 8.0%	US$5.7	US$6.0	US$6.0	US$5.9	US$5.7	US$5.5	US$5.2	US$5.0	US$4.7	US$4.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$54m

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. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.0%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$9.5m× (1 + 1.2%) ÷ (8.0%– 1.2%) = US$141m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$141m÷ ( 1 + 8.0%)¹⁰= US$65m

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$119m. 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£4.2, the company appears a touch undervalued at a 26% 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

We would point out that 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 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 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 8.0%, which is based on a levered beta of 0.979. 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

Next Steps:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Water Intelligence, we've put together three additional elements you should explore:

1. Risks: We feel that you should assess the 2 warning signs for Water Intelligence we've flagged before making an investment in the company.
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. 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.