Does the March share price for Energy Recovery, Inc. (NASDAQ:ERII) 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 today’s value. I will use the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.
Crunching the numbers
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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$6.50m||US$29.6m||US$32.0m||US$33.8m||US$35.3m||US$36.6m||US$37.7m||US$38.8m||US$39.7m||US$40.6m|
|Growth Rate Estimate Source||Analyst x4||Analyst x4||Analyst x1||Est @ 5.65%||Est @ 4.48%||Est @ 3.66%||Est @ 3.08%||Est @ 2.68%||Est @ 2.4%||Est @ 2.2%|
|Present Value ($, Millions) Discounted @ 7.1%||US$6.1||US$25.8||US$26.1||US$25.7||US$25.1||US$24.3||US$23.4||US$22.5||US$21.5||US$20.5|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$220m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.7%. We discount the terminal cash flows to today’s value at a cost of equity of 7.1%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$41m× (1 + 1.7%) ÷ 7.1%– 1.7%) = US$776m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$776m÷ ( 1 + 7.1%)10= US$392m
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 US$612m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$7.1, the company appears quite undervalued at a 35% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 Energy Recovery 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 7.1%, which is based on a levered beta of 0.978. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” 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 to differ from the intrinsic value? For Energy Recovery, We’ve compiled three important aspects you should look at:
- Risks: Be aware that Energy Recovery is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning…
- Future Earnings: How does ERII’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.
- 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 US stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
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