An Intrinsic Calculation For ECO Animal Health Group plc (LON:EAH) Suggests It's 38% Undervalued

Key Insights

• ECO Animal Health Group's estimated fair value is UK£1.6 based on 2 Stage Free Cash Flow to Equity
• Current share price of UK£1.0 suggests ECO Animal Health Group is 38% undervalued
• Industry average of 37% suggests ECO Animal Health Group's peers are currently trading at a lower discount

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ECO Animal Health Group plc (LON:EAH) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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. 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 ECO Animal Health Group

The Model

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of 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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£1.18m	UK£4.21m	UK£4.78m	UK£5.18m	UK£5.50m	UK£5.76m	UK£5.96m	UK£6.12m	UK£6.26m	UK£6.38m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ 8.40%	Est @ 6.18%	Est @ 4.62%	Est @ 3.53%	Est @ 2.77%	Est @ 2.24%	Est @ 1.86%
Present Value (£, Millions) Discounted @ 6.1%	UK£1.1	UK£3.7	UK£4.0	UK£4.1	UK£4.1	UK£4.0	UK£3.9	UK£3.8	UK£3.7	UK£3.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£36m

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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.1%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£6.4m× (1 + 1.0%) ÷ (6.1%– 1.0%) = UK£127m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£127m÷ ( 1 + 6.1%)¹⁰= UK£70m

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£106m. 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£1.0, the company appears quite good value at a 38% 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 ECO Animal Health Group 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 0.800. 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 ECO Animal Health Group

Looking Ahead:

Although the valuation of a company is important, 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 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 ECO Animal Health Group, we've compiled three essential items you should further research:

1. Risks: Take risks, for example - ECO Animal Health Group has 2 warning signs we think you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for EAH'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.