Are Eckoh plc (LON:ECK) Investors Paying Above The Intrinsic Value?

Today we will run through one way of estimating the intrinsic value of Eckoh plc (LON:ECK) by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

See our latest analysis for Eckoh

What's the estimated valuation?

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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (£, Millions)	UK£5.16m	UK£7.60m	UK£8.09m	UK£8.49m	UK£8.80m	UK£9.06m	UK£9.27m	UK£9.44m	UK£9.60m	UK£9.74m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Est @ 6.51%	Est @ 4.85%	Est @ 3.7%	Est @ 2.89%	Est @ 2.32%	Est @ 1.93%	Est @ 1.65%	Est @ 1.45%
Present Value (£, Millions) Discounted @ 7.5%	UK£4.8	UK£6.6	UK£6.5	UK£6.3	UK£6.1	UK£5.9	UK£5.6	UK£5.3	UK£5.0	UK£4.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£56m

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 7.5%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK£9.7m× (1 + 1.0%) ÷ (7.5%– 1.0%) = UK£150m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£150m÷ ( 1 + 7.5%)¹⁰= UK£73m

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£129m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£0.6, the company appears slightly overvalued at the time of writing. 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

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 Eckoh 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 7.5%, which is based on a levered beta of 1.097. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For Eckoh, there are three further factors you should consider:

1. Financial Health: Does ECK have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ECK'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. 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. 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.
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