Does the April share price for Elica S.p.A. (BIT:ELC) 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 today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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.
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. 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 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) estimate
|Levered FCF (€, Millions)||€11.5m||€16.7m||€23.0m||€27.7m||€31.7m||€35.1m||€37.8m||€40.0m||€41.8m||€43.2m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Analyst x1||Est @ 20.33%||Est @ 14.59%||Est @ 10.58%||Est @ 7.77%||Est @ 5.8%||Est @ 4.42%||Est @ 3.46%|
|Present Value (€, Millions) Discounted @ 11%||€10.3||€13.5||€16.7||€18.1||€18.6||€18.5||€17.9||€17.1||€16.0||€14.9|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €161m
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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 11%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = €43m× (1 + 1.2%) ÷ 11%– 1.2%) = €437m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €437m÷ ( 1 + 11%)10= €151m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €312m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of €2.8, the company appears quite undervalued at a 44% 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. 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 Elica 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 11%, which is based on a levered beta of 1.217. 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. What is the reason for the share price to differ from the intrinsic value? For Elica, We've put together three fundamental factors you should further examine:
- Risks: We feel that you should assess the 2 warning signs for Elica we've flagged before making an investment in the company.
- Future Earnings: How does ELC'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the BIT every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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