Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Image Sensing Systems, Inc. (NASDAQ:ISNS) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's 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.
Is Image Sensing Systems fairly valued?
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$1.51m||US$1.54m||US$1.57m||US$1.61m||US$1.64m||US$1.68m||US$1.72m||US$1.75m||US$1.79m||US$1.83m|
|Growth Rate Estimate Source||Est @ 2.18%||Est @ 2.19%||Est @ 2.2%||Est @ 2.21%||Est @ 2.21%||Est @ 2.21%||Est @ 2.21%||Est @ 2.22%||Est @ 2.22%||Est @ 2.22%|
|Present Value ($, Millions) Discounted @ 8.7%||US$1.4||US$1.3||US$1.2||US$1.1||US$1.1||US$1.0||US$1.0||US$0.9||US$0.8||US$0.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$10m
After calculating the present value of future cash flows in the intial 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 10-year government bond rate of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$1.8m× (1 + 2.2%) ÷ 8.7%– 2.2%) = US$29m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$29m÷ ( 1 + 8.7%)10= US$12m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$22m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$3.6, the company appears about fair value at a 14% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Image Sensing Systems 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 8.7%, which is based on a levered beta of 1.086. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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 Image Sensing Systems, We've put together three relevant aspects you should look at:
- Risks: You should be aware of the 3 warning signs for Image Sensing Systems (1 is potentially serious!) we've uncovered before considering an investment in the company.
- 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!
- Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQCM 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. 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. Thank you for reading.