Today we’re doing a simple run-through of a valuation methodology that will estimate Electro Optic Systems Holdings Limited’s (ASX: EOS) attractiveness as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will use to do this. Don’t let the jargon put you off, the math behind it is actually pretty simple.
We point out that there are many ways to rate a company and, like with DCF, each technique has advantages and disadvantages in certain scenarios. If you want to find out more about the intrinsic value, you should read the Simply Wall St analysis model.
Check out our latest analysis for Electro Optic Systems Holdings
The method
We use what is called a 2-step model, which simply means that we have two different growth rates for the company’s cash flows. In general, the first stage is higher growth and the second stage is lower growth phase. First, we need to get estimates of the next ten years of cash flow. We use analyst estimates whenever possible. However, if these are not available, we extrapolate the previous free cash flow (FCF) from the most recent estimate or reported value. We assume that companies with shrinking free cash flow will slow their rate of contraction and that companies with increasing free cash flow will slow their growth rate over this period. We do this to reflect that growth tends to slow down more in the first few years than in later years.
A DCF is all about the idea that a dollar in the future is worth less than a dollar today. Hence, we need to discount the sum of these future cash flows to get a present value estimate:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Leverage FCF (A $, million) | AU $ 85.6 million | AU $ 8.50 million | AU $ 37.0 million | AU $ 64.0 million | AU $ 61.1 million | AU $ 59.6 million | AU $ 59.0 million | A $ 58.9 million | AU $ 59.3 million | AU $ 60.0 million |
Source for growth rate estimation | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Actual @ -4.51% | Est @ -2.48% | Est @ -1.06% | East @ -0.06% | Est @ 0.63% | Est @ 1.12% |
Present Value (A $, Million) Discount @ 7.5% | A $ 79.7 | AU $ 7.4 | A $ 29.8 | AU $ 48.0 | A $ 42.6 | A $ 38.7 | A $ 35.6 | AU $ 33.1 | AU $ 31.0 | A $ 29.2 |
(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = AU $ 375 million
After calculating the present value of future cash flows in the first 10 years, we need to calculate the terminal value that takes into account all future cash flows beyond the first stage. A very conservative growth rate is used that cannot exceed that of any country’s GDP growth for a number of reasons. In this case, we used the 5-year average 10-year government bond yield (2.3%) to estimate future growth. Similar to the 10-year growth period, we discount future cash flows to today’s value using a cost of equity rate of 7.5%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU $ 60 million × (1 + 2.3%) ÷ (7.5% – 2.3%) = AU $ 1.2b
Present value of the terminal value (PVTV)= TV / (1 + r) 10 = AU $ 1.2 billion (1 + 7.5%) 10 = AU $ 573 million
The total value is the sum of the cash flows for the next ten years plus the discounted final value, which results in the total net present value, which in this case is AU $ 948 million. In the last step, we divide the equity value by the number of shares issued. Compared to the current share price of AU $ 6.6, the company appears at fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – garbage in, garbage out.
ASX: EOS Discounted Cash Flow November 23, 2020
Important assumptions
The above calculation depends heavily on two assumptions. The first is the discount rate and the other is the cash flows. Part of the investment is making your own assessment of a company’s future performance. So try it yourself and check your own assumptions. The DCF also does not take into account the possible cyclical nature of an industry or the future capital requirements of a company, so it does not give a complete picture of a company’s potential performance. Given that we consider Electro Optic Systems Holdings a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) responsible for debt. In this calculation we used 7.5% based on a leverage beta of 0.866. Beta is a measure of the volatility of a stock compared to the overall market. We get our beta from the industry average beta of comparable companies around the world with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Go on:
While evaluating a company is important, it is just one of many factors that you need to evaluate for a company. With a DCF model, it is not possible to get a foolproof rating. Rather, it should be seen as a guide to “what assumptions must be made for this stock to be undervalued or overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can change the overall result dramatically. For Electro Optic Systems Holdings, we’ve rounded up three key points that you should investigate further:
- Risks: For example, we discovered 2 warning signs for Electro Optic Systems Holdings You should know this before investing here.
- administration: Did insiders raise their stocks to use market sentiment to shape EOS’s future prospects? Find out more about the CEO’s compensation and governance factors in our management and board analysis.
- Other solid companies: Low debt, high returns on equity, and good past performance are fundamental to a strong business. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you might not have considered!
PS. Simply Wall St updates its DCF calculation for every Australian share on a daily basis. So if you want to find out the intrinsic value of another stock, just search here.
Funded
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This article from Simply Wall St is of a general nature. It is not a recommendation to buy or sell stocks and does not take into account your goals or your financial situation. We want to provide you with a long-term, focused analysis based on fundamental data. Note that our analysis may not take into account the latest price sensitive company announcements or quality materials. Simply Wall St has no position in the stocks mentioned.
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