Digi International Inc.'s (NASDAQ:DGII) Intrinsic Value Is Potentially 85% Above Its Share Price
Key Insights
Digi International's estimated fair value is US$44.82 based on 2 Stage Free Cash Flow to Equity
Digi International is estimated to be 46% undervalued based on current share price of US$24.26
The US$36.14 analyst price target for DGII is 19% less than our estimate of fair value
Today we will run through one way of estimating the intrinsic value of Digi International Inc. (NASDAQ:DGII) by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest analysis for Digi International
The Calculation
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$65.1m | US$74.6m | US$81.6m | US$87.6m | US$92.6m | US$97.0m | US$100.8m | US$104.2m | US$107.4m | US$110.5m |
Growth Rate Estimate Source | Analyst x2 | Analyst x2 | Est @ 9.43% | Est @ 7.27% | Est @ 5.75% | Est @ 4.69% | Est @ 3.95% | Est @ 3.43% | Est @ 3.07% | Est @ 2.81% |
Present Value ($, Millions) Discounted @ 7.6% | US$60.5 | US$64.4 | US$65.5 | US$65.3 | US$64.2 | US$62.5 | US$60.4 | US$58.0 | US$55.6 | US$53.1 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$610m
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. 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.6%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$110m× (1 + 2.2%) ÷ (7.6%– 2.2%) = US$2.1b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.1b÷ ( 1 + 7.6%)10= US$1.0b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$1.6b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$24.3, the company appears quite undervalued at a 46% 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.
Important 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 Digi International 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 7.6%, which is based on a levered beta of 1.076. 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 Digi International
Strength
Earnings growth over the past year exceeded the industry.
Net debt to equity ratio below 40%.
Weakness
Earnings growth over the past year is below its 5-year average.
Interest payments on debt are not well covered.
Opportunity
Annual earnings are forecast to grow for the next 2 years.
Trading below our estimate of fair value by more than 20%.
Threat
Debt is not well covered by operating cash flow.
Annual earnings are forecast to grow slower than the American market.
Looking Ahead:
Although the valuation of a company is important, it is only one of many factors that you need to assess 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. Why is the intrinsic value higher than the current share price? For Digi International, there are three pertinent factors you should explore:
Financial Health: Does DGII have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Future Earnings: How does DGII'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.
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. 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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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.
