Stock Analysis

Calculating The Fair Value Of Electro-Sensors, Inc. (NASDAQ:ELSE)

NasdaqCM:ELSE
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In this article we are going to estimate the intrinsic value of Electro-Sensors, Inc. (NASDAQ:ELSE) by projecting its future cash flows and then discounting them to today's 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!

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Electro-Sensors

Step by step through the calculation

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. 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.

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) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$641.0k US$743.5k US$831.1k US$904.5k US$965.7k US$1.02m US$1.06m US$1.10m US$1.13m US$1.17m
Growth Rate Estimate Source Est @ 22% Est @ 15.99% Est @ 11.78% Est @ 8.83% Est @ 6.77% Est @ 5.33% Est @ 4.32% Est @ 3.61% Est @ 3.12% Est @ 2.77%
Present Value ($, Millions) Discounted @ 6.8% US$0.6 US$0.7 US$0.7 US$0.7 US$0.7 US$0.7 US$0.7 US$0.6 US$0.6 US$0.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.0m

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 (2.0%) 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 6.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$1.2m× (1 + 2.0%) ÷ (6.8%– 2.0%) = US$25m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$25m÷ ( 1 + 6.8%)10= US$13m

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$19m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$5.3, the company appears about fair value at a 4.7% 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
NasdaqCM:ELSE Discounted Cash Flow February 1st 2022

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Electro-Sensors 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 6.8%, which is based on a levered beta of 1.104. 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 shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Electro-Sensors, there are three relevant aspects you should further research:

  1. Risks: Case in point, we've spotted 2 warning signs for Electro-Sensors you should be aware of, and 1 of them doesn't sit too well with us.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ELSE's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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.

Valuation is complex, but we're here to simplify it.

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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.