Estimating The Fair Value Of IGas Energy plc (LON:IGAS)
Today we will run through one way of estimating the intrinsic value of IGas Energy plc (LON:IGAS) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 IGas Energy
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. To start off with, we need to estimate 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF (£, Millions) | UK£1.40m | UK£1.53m | UK£1.63m | UK£1.71m | UK£1.77m | UK£1.82m | UK£1.87m | UK£1.90m | UK£1.93m | UK£1.96m |
Growth Rate Estimate Source | Analyst x1 | Est @ 9.01% | Est @ 6.61% | Est @ 4.93% | Est @ 3.75% | Est @ 2.92% | Est @ 2.35% | Est @ 1.94% | Est @ 1.66% | Est @ 1.46% |
Present Value (£, Millions) Discounted @ 12% | UK£1.2 | UK£1.2 | UK£1.1 | UK£1.1 | UK£1.0 | UK£0.9 | UK£0.8 | UK£0.8 | UK£0.7 | UK£0.6 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£9.0m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.0%) 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 12%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK£2.0m× (1 + 1.0%) ÷ (12%– 1.0%) = UK£18m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£18m÷ ( 1 + 12%)10= UK£5.5m
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£15m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.1, the company appears around fair value at the time of writing. 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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 IGas Energy 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 12%, which is based on a levered beta of 1.894. 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.
Looking Ahead:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. 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 IGas Energy, we've put together three relevant elements you should explore:
Risks: For example, we've discovered 4 warning signs for IGas Energy that you should be aware of before investing here.
Future Earnings: How does IGAS'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: 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.
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. 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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