Estimating The Fair Value Of ERM Power Limited (ASX:EPW)
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Does the May share price for ERM Power Limited (ASX:EPW) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Check out our latest analysis for ERM Power
Crunching the numbers
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. 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 are 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) forecast
2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | |
Levered FCF (A$, Millions) | A$88.00 | A$62.00 | A$41.00 | A$29.57 | A$24.01 | A$21.01 | A$19.32 | A$18.37 | A$17.86 | A$17.64 |
Growth Rate Estimate Source | Analyst x1 | Analyst x1 | Analyst x1 | Est @ -27.87% | Est @ -18.81% | Est @ -12.48% | Est @ -8.04% | Est @ -4.93% | Est @ -2.76% | Est @ -1.24% |
Present Value (A$, Millions) Discounted @ 7.08% | A$82.18 | A$54.07 | A$33.39 | A$22.49 | A$17.05 | A$13.94 | A$11.97 | A$10.63 | A$9.65 | A$8.90 |
Present Value of 10-year Cash Flow (PVCF)= A$264.29m
"Est" = FCF growth rate estimated by Simply Wall St
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = AU$18m × (1 + 2.3%) ÷ (7.1% – 2.3%) = AU$379m
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = A$AU$379m ÷ ( 1 + 7.1%)10 = A$191.01m
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 A$455.30m. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of A$1.85. Relative to the current share price of A$1.77, the company appears about fair value at a 4.5% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 ERM Power 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 0.800. 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.
Next Steps:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching 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?" 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 ERM Power, I've compiled three fundamental factors you should look at:
Financial Health: Does EPW 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 EPW'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of EPW? 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 ASX every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
