An Intrinsic Calculation For Origin Enterprises plc (ISE:OIZ) Suggests It's 38% Undervalued

Does the January share price for Origin Enterprises plc (ISE:OIZ) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present 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. 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 Origin Enterprises

Step by step through the calculation

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. 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) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (€, Millions)	€25.6m	€41.1m	€40.0m	€39.3m	€38.9m	€38.7m	€38.6m	€38.6m	€38.7m	€38.8m
Growth Rate Estimate Source	Analyst x3	Analyst x2	Est @ -2.72%	Est @ -1.74%	Est @ -1.04%	Est @ -0.56%	Est @ -0.22%	Est @ 0.02%	Est @ 0.18%	Est @ 0.3%
Present Value (€, Millions) Discounted @ 6.4%	€24.1	€36.3	€33.2	€30.7	€28.5	€26.7	€25.0	€23.5	€22.2	€20.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €271m

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 0.6%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = €39m× (1 + 0.6%) ÷ (6.4%– 0.6%) = €671m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €671m÷ ( 1 + 6.4%)¹⁰= €361m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €632m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of €3.1, the company appears quite undervalued 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. 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 Origin Enterprises 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 6.4%, which is based on a levered beta of 0.898. 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.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess 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. What is the reason for the share price sitting below the intrinsic value? For Origin Enterprises, we've compiled three further aspects you should consider:

1. Risks: Every company has them, and we've spotted 3 warning signs for Origin Enterprises you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for OIZ's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ISE 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. 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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