Are Investors Undervaluing Expert System S.p.A. (BIT:EXSY) By 49%?

In this article we are going to estimate the intrinsic value of Expert System S.p.A. (BIT:EXSY) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Expert System

Step by step through the calculation

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. 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, 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)	-€13.4m	-€10.8m	-€1.00m	€11.2m	€18.4m	€26.9m	€35.7m	€44.1m	€51.6m	€58.0m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Est @ 64.85%	Est @ 45.98%	Est @ 32.77%	Est @ 23.52%	Est @ 17.05%	Est @ 12.52%
Present Value (€, Millions) Discounted @ 13%	-€11.9	-€8.5	-€0.7	€6.9	€10.0	€12.9	€15.2	€16.6	€17.2	€17.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €74m

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 (2.0%) 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 13%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = €58m× (1 + 2.0%) ÷ (13%– 2.0%) = €538m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €538m÷ ( 1 + 13%)¹⁰= €159m

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 €233m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of €2.3, the company appears quite undervalued at a 49% 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.

Important assumptions

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 Expert System 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 13%, which is based on a levered beta of 1.096. 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:

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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value? For Expert System, we've put together three important aspects you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Expert System (at least 1 which doesn't sit too well with us) , and understanding these should be part of your investment process.
2. Future Earnings: How does EXSY'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.
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 Italian 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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