Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of NeoPhotonics Corporation (NYSE:NPTN) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in December 2018 so be sure check out the updated calculation by following the link below.
Check out our latest analysis for NeoPhotonics
The model
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow forecast
| 2019 | 2020 | 2021 | 2022 | 2023 | |
| Levered FCF ($, Millions) | $16.19 | $32.35 | $33.13 | $33.94 | $34.77 |
| Source | Analyst x1 | Analyst x1 | Est @ 2.44% | Est @ 2.44% | Est @ 2.44% |
| Present Value Discounted @ 12.36% | $14.41 | $25.62 | $23.36 | $21.30 | $19.42 |
Present Value of 5-year Cash Flow (PVCF)= US$104m
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 12.4%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$35m × (1 + 2.9%) ÷ (12.4% – 2.9%) = US$381m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$381m ÷ ( 1 + 12.4%)5 = US$213m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US$317m. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of $6.88. Compared to the current share price of $7.74, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
The assumptions
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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at NeoPhotonics as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 12.4%, which is based on a levered beta of 1.334. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
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. For NPTN, I’ve put together three important aspects you should further examine:
- Financial Health: Does NPTN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does NPTN’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of NPTN? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.