Today we will run through one way of estimating the intrinsic value of EKF Diagnostics Holdings plc (LON:EKF) by estimating the company's future cash flows and discounting them to their present 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!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Step by step through the calculation
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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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
|Levered FCF (£, Millions)||UK£13.9m||UK£16.1m||UK£18.0m||UK£19.5m||UK£20.7m||UK£21.7m||UK£22.4m||UK£23.0m||UK£23.6m||UK£24.0m|
|Growth Rate Estimate Source||Analyst x1||Est @ 16.05%||Est @ 11.53%||Est @ 8.37%||Est @ 6.16%||Est @ 4.61%||Est @ 3.53%||Est @ 2.77%||Est @ 2.24%||Est @ 1.87%|
|Present Value (£, Millions) Discounted @ 6.2%||UK£13.1||UK£14.3||UK£15.0||UK£15.4||UK£15.4||UK£15.1||UK£14.8||UK£14.3||UK£13.8||UK£13.2|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£144m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.2%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£24m× (1 + 1.0%) ÷ (6.2%– 1.0%) = UK£470m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£470m÷ ( 1 + 6.2%)10= UK£259m
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 UK£403m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.8, the company appears about fair value at a 8.5% 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.
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 EKF Diagnostics Holdings 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 6.2%, which is based on a levered beta of 0.865. 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.
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For EKF Diagnostics Holdings, there are three essential aspects you should further research:
- Risks: For instance, we've identified 2 warning signs for EKF Diagnostics Holdings (1 is a bit unpleasant) you should be aware of.
- Future Earnings: How does EKF'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 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. 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.
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EKF Diagnostics Holdings
EKF Diagnostics Holdings plc designs, develops, manufactures, and sells diagnostic instruments, reagents, and other ancillary products in Europe, the Middle East, the Americas, Asia, Africa, and internationally.
Flawless balance sheet and undervalued.