Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Instem plc (LON:INS) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
What's the estimated valuation?
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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (£, Millions)||UK£7.27m||UK£9.30m||UK£10.8m||UK£12.0m||UK£13.0m||UK£13.8m||UK£14.5m||UK£15.0m||UK£15.4m||UK£15.7m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 16.06%||Est @ 11.51%||Est @ 8.33%||Est @ 6.1%||Est @ 4.54%||Est @ 3.45%||Est @ 2.68%||Est @ 2.15%|
|Present Value (£, Millions) Discounted @ 5.1%||UK£6.9||UK£8.4||UK£9.3||UK£9.9||UK£10.2||UK£10.3||UK£10.2||UK£10.0||UK£9.8||UK£9.5|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£94m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (0.9%) 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 5.1%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£16m× (1 + 0.9%) ÷ (5.1%– 0.9%) = UK£375m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£375m÷ ( 1 + 5.1%)10= UK£228m
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£322m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£8.0, the company appears quite undervalued at a 45% 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.
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 Instem 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 5.1%, which is based on a levered beta of 0.863. 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.
Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Instem, we've compiled three additional elements you should explore:
- Risks: You should be aware of the 2 warning signs for Instem we've uncovered before considering an investment in the company.
- Future Earnings: How does INS'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. 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.