Estimating The Fair Value Of Innovative Solutions and Support, Inc. (NASDAQ:ISSC)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Innovative Solutions and Support, Inc. (NASDAQ:ISSC) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Innovative Solutions and Support

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$5.48m	US$5.72m	US$5.94m	US$6.12m	US$6.30m	US$6.46m	US$6.61m	US$6.76m	US$6.90m	US$7.05m
Growth Rate Estimate Source	Est @ 5.58%	Est @ 4.49%	Est @ 3.73%	Est @ 3.19%	Est @ 2.81%	Est @ 2.55%	Est @ 2.37%	Est @ 2.24%	Est @ 2.15%	Est @ 2.09%
Present Value ($, Millions) Discounted @ 5.3%	US$5.2	US$5.2	US$5.1	US$5.0	US$4.9	US$4.7	US$4.6	US$4.5	US$4.3	US$4.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$47m

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 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$7.0m× (1 + 1.9%) ÷ (5.3%– 1.9%) = US$212m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$212m÷ ( 1 + 5.3%)¹⁰= US$126m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$173m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$8.1, the company appears about fair value at a 19% 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

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. 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 Innovative Solutions and Support 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 5.3%, 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Innovative Solutions and Support, there are three pertinent items you should consider:

1. Risks: Be aware that Innovative Solutions and Support is showing 2 warning signs in our investment analysis , you should know about...
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ISSC'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 NASDAQGS 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.