How far off is IKONICS Corporation (NASDAQ:IKNX) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
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.
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$614.5k||US$786.1k||US$944.7k||US$1.08m||US$1.20m||US$1.30m||US$1.38m||US$1.46m||US$1.52m||US$1.57m|
|Growth Rate Estimate Source||Est @ 39.04%||Est @ 27.94%||Est @ 20.17%||Est @ 14.73%||Est @ 10.92%||Est @ 8.26%||Est @ 6.39%||Est @ 5.09%||Est @ 4.17%||Est @ 3.53%|
|Present Value ($, Millions) Discounted @ 7.1%||US$0.6||US$0.7||US$0.8||US$0.8||US$0.9||US$0.9||US$0.9||US$0.8||US$0.8||US$0.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.0m
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 7.1%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.6m× (1 + 2.0%) ÷ (7.1%– 2.0%) = US$32m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$32m÷ ( 1 + 7.1%)10= US$16m
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$23m. 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$9.8, the company appears about fair value at a 16% 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.
Now 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 IKONICS 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 0.965. 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. 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. 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. For IKONICS, we've compiled three additional items you should look at:
- Risks: Take risks, for example - IKONICS has 4 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for IKNX's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every American 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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