A Look At The Fair Value Of Luna Innovations Incorporated (NASDAQ:LUNA)

Key Insights

• The projected fair value for Luna Innovations is US$7.88 based on 2 Stage Free Cash Flow to Equity
• With US$7.10 share price, Luna Innovations appears to be trading close to its estimated fair value
• The average premium for Luna Innovations' competitorsis currently 38%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Luna Innovations Incorporated (NASDAQ:LUNA) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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

Check out our latest analysis for Luna Innovations

The Model

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. 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$9.78m	US$12.7m	US$15.0m	US$16.9m	US$18.6m	US$20.0m	US$21.1m	US$22.1m	US$23.0m	US$23.8m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 17.59%	Est @ 12.95%	Est @ 9.70%	Est @ 7.42%	Est @ 5.83%	Est @ 4.71%	Est @ 3.93%	Est @ 3.39%
Present Value ($, Millions) Discounted @ 8.9%	US$9.0	US$10.8	US$11.6	US$12.0	US$12.1	US$12.0	US$11.6	US$11.2	US$10.7	US$10.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$111m

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 (2.1%) 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 8.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$24m× (1 + 2.1%) ÷ (8.9%– 2.1%) = US$358m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$358m÷ ( 1 + 8.9%)¹⁰= US$153m

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$264m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$7.1, the company appears about fair value at a 9.9% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

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 Luna Innovations 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 8.9%, which is based on a levered beta of 1.142. 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.

SWOT Analysis for Luna Innovations

Moving On:

Although the valuation of a company is important, it 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Luna Innovations, we've put together three relevant elements you should assess:

1. Risks: We feel that you should assess the 4 warning signs for Luna Innovations (1 is concerning!) we've flagged before making an investment in the company.
2. Future Earnings: How does LUNA'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 NASDAQCM every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.