Tristel plc (LON:TSTL) Shares Could Be 22% Below Their Intrinsic Value Estimate

Today we will run through one way of estimating the intrinsic value of Tristel plc (LON:TSTL) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Tristel

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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (£, Millions)	UK£5.30m	UK£5.25m	UK£5.80m	UK£7.00m	UK£8.50m	UK£9.50m	UK£10.3m	UK£11.0m	UK£11.5m	UK£11.9m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ 11.81%	Est @ 8.53%	Est @ 6.24%	Est @ 4.63%	Est @ 3.5%
Present Value (£, Millions) Discounted @ 5.3%	UK£5.0	UK£4.7	UK£5.0	UK£5.7	UK£6.6	UK£7.0	UK£7.2	UK£7.3	UK£7.2	UK£7.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£62m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 0.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = UK£12m× (1 + 0.9%) ÷ (5.3%– 0.9%) = UK£272m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£272m÷ ( 1 + 5.3%)¹⁰= UK£163m

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£225m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£3.7, 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.

The 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 Tristel 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 5.3%, which is based on a levered beta of 0.908. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Tristel, we've put together three relevant aspects you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Tristel , and understanding them should be part of your investment process.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for TSTL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. 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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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.