Estimating The Fair Value Of Ergomed plc (LON:ERGO)

Simply Wall St
·6 min read

Key Insights

  • Ergomed's estimated fair value is UK£12.31 based on 2 Stage Free Cash Flow to Equity

  • Ergomed's UK£10.36 share price indicates it is trading at similar levels as its fair value estimate

  • The UK£14.45 analyst price target for ERGO is 17% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of Ergomed plc (LON:ERGO) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.

See our latest analysis for Ergomed

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF (£, Millions)

UK£22.1m

UK£25.1m

UK£29.0m

UK£32.5m

UK£37.0m

UK£40.3m

UK£42.9m

UK£45.0m

UK£46.7m

UK£48.1m

Growth Rate Estimate Source

Analyst x6

Analyst x4

Analyst x2

Analyst x2

Analyst x1

Est @ 8.79%

Est @ 6.50%

Est @ 4.89%

Est @ 3.77%

Est @ 2.98%

Present Value (£, Millions) Discounted @ 7.4%

UK£20.6

UK£21.7

UK£23.4

UK£24.4

UK£25.9

UK£26.2

UK£26.0

UK£25.4

UK£24.5

UK£23.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£241m

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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£48m× (1 + 1.2%) ÷ (7.4%– 1.2%) = UK£775m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£775m÷ ( 1 + 7.4%)10= UK£379m

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 UK£620m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£10.4, the company appears about fair value at a 16% 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
dcf

Important 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 Ergomed 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 7.4%, which is based on a levered beta of 0.899. 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 Ergomed

Strength

  • Currently debt free.

Weakness

  • Earnings growth over the past year underperformed the Life Sciences industry.

  • Shareholders have been diluted in the past year.

Opportunity

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

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

Threat

  • Revenue is forecast to grow slower than 20% per year.

Next Steps:

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. 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 Ergomed, there are three important aspects you should further examine:

  1. Risks: For instance, we've identified 2 warning signs for Ergomed that you should be aware of.

  2. Future Earnings: How does ERGO'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 AIM 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.

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