Estimating The Fair Value Of essensys plc (LON:ESYS)

Key Insights

• essensys' estimated fair value is UK£0.52 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£0.56 suggests essensys is potentially trading close to its fair value

• Industry average of 28% suggests essensys' peers are currently trading at a higher premium to fair value

Does the March share price for essensys plc (LON:ESYS) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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.

View our latest analysis for essensys

Step By Step Through The Calculation

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	-UK£15.9m	-UK£2.80m	UK£1.50m	UK£2.19m	UK£2.89m	UK£3.56m	UK£4.14m	UK£4.63m	UK£5.03m	UK£5.35m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 45.72%	Est @ 32.35%	Est @ 22.99%	Est @ 16.44%	Est @ 11.85%	Est @ 8.64%	Est @ 6.39%
Present Value (£, Millions) Discounted @ 8.3%	-UK£14.7	-UK£2.4	UK£1.2	UK£1.6	UK£1.9	UK£2.2	UK£2.4	UK£2.4	UK£2.4	UK£2.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -UK£540k

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 8.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£5.4m× (1 + 1.2%) ÷ (8.3%– 1.2%) = UK£75m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£75m÷ ( 1 + 8.3%)¹⁰= UK£34m

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£33m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.6, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 essensys 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 8.3%, which is based on a levered beta of 1.032. 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 essensys

Strength

• Currently debt free.

Weakness

• No major weaknesses identified for ESYS.

Opportunity

• Good value based on P/S ratio compared to estimated Fair P/S ratio.

Threat

• Has less than 3 years of cash runway based on current free cash flow.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For essensys, we've put together three fundamental aspects you should further examine:

1. Risks: We feel that you should assess the 2 warning signs for essensys (1 makes us a bit uncomfortable!) we've flagged before making an investment in the company.

2. Future Earnings: How does ESYS'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. 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.

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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