Calculating The Fair Value Of Eleco Plc (LON:ELCO)

Key Insights

• Eleco's estimated fair value is UK£1.08 based on 2 Stage Free Cash Flow to Equity

• Eleco's UK£0.93 share price indicates it is trading at similar levels as its fair value estimate

• Eleco's peers are currently trading at a premium of 77% on average

How far off is Eleco Plc (LON:ELCO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Eleco

Is Eleco 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. To begin with, we have to get estimates of the next ten years of cash flows. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£3.17m	UK£4.19m	UK£4.60m	UK£4.90m	UK£5.14m	UK£5.35m	UK£5.53m	UK£5.68m	UK£5.82m	UK£5.95m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Est @ 6.47%	Est @ 5.02%	Est @ 4.01%	Est @ 3.30%	Est @ 2.80%	Est @ 2.45%	Est @ 2.21%
Present Value (£, Millions) Discounted @ 7.1%	UK£3.0	UK£3.7	UK£3.7	UK£3.7	UK£3.6	UK£3.5	UK£3.4	UK£3.3	UK£3.1	UK£3.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£34m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (1.6%) 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 7.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£5.9m× (1 + 1.6%) ÷ (7.1%– 1.6%) = UK£110m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£110m÷ ( 1 + 7.1%)¹⁰= UK£55m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£89m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£0.9, the company appears about fair value at a 15% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Eleco 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 7.1%, which is based on a levered beta of 1.004. 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 Eleco

Strength

• Currently debt free.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Software market.

Opportunity

• Annual earnings are forecast to grow faster than the British market.

• Current share price is below our estimate of fair value.

Threat

• No apparent threats visible for ELCO.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. For Eleco, we've put together three pertinent items you should assess:

1. Risks: Every company has them, and we've spotted 1 warning sign for Eleco you should know about.

2. Future Earnings: How does ELCO'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 British 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. 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.