Stock Analysis

An Intrinsic Calculation For II-VI Incorporated (NASDAQ:IIVI) Suggests It's 45% Undervalued

  •  Updated
NasdaqGS:COHR
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Does the June share price for II-VI Incorporated (NASDAQ:IIVI) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for II-VI

Is II-VI fairly valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$530.1m US$517.4m US$651.7m US$741.4m US$817.3m US$880.8m US$933.9m US$978.9m US$1.02b US$1.05b
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Est @ 13.77% Est @ 10.24% Est @ 7.76% Est @ 6.03% Est @ 4.82% Est @ 3.97% Est @ 3.38%
Present Value ($, Millions) Discounted @ 8.1% US$491 US$443 US$517 US$544 US$555 US$553 US$543 US$527 US$507 US$485

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.2b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.1b× (1 + 2.0%) ÷ (8.1%– 2.0%) = US$18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$18b÷ ( 1 + 8.1%)10= US$8.2b

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$13b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$70.1, the company appears quite good value at a 45% 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
NasdaqGS:IIVI Discounted Cash Flow June 24th 2021

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 II-VI 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 8.1%, which is based on a levered beta of 1.285. 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 ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price sitting below the intrinsic value? For II-VI, there are three further aspects you should further research:

  1. Risks: Be aware that II-VI is showing 1 warning sign in our investment analysis , you should know about...
  2. Future Earnings: How does IIVI'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 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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