Is Information Services Group, Inc. (NASDAQ:III) Trading At A 33% Discount?

By
Simply Wall St
Published
November 02, 2020
NasdaqGM:III

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Information Services Group, Inc. (NASDAQ:III) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

See our latest analysis for Information Services Group

The model

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$11.6m US$13.5m US$12.1m US$14.1m US$14.6m US$15.1m US$15.6m US$16.0m US$16.5m US$16.9m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Analyst x1 Est @ 3.89% Est @ 3.39% Est @ 3.04% Est @ 2.79% Est @ 2.62% Est @ 2.5%
Present Value ($, Millions) Discounted @ 11% US$10.5 US$11.0 US$8.8 US$9.2 US$8.6 US$8.0 US$7.4 US$6.9 US$6.3 US$5.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$82m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.2%) 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 11%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$17m× (1 + 2.2%) ÷ (11%– 2.2%) = US$192m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$192m÷ ( 1 + 11%)10= US$66m

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$148m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$2.1, the company appears quite good value at a 33% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NasdaqGM:III Discounted Cash Flow November 2nd 2020

The 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. 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 Information Services Group 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 11%, which is based on a levered beta of 1.497. 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.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Information Services Group, we've put together three additional aspects you should consider:

  1. Risks: Every company has them, and we've spotted 2 warning signs for Information Services Group (of which 1 is a bit unpleasant!) you should know about.
  2. Future Earnings: How does III'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 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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