Are Investors Undervaluing Nephros, Inc. (NASDAQ:NEPH) By 45%?
Key Insights
The projected fair value for Nephros is US$4.69 based on 2 Stage Free Cash Flow to Equity
Current share price of US$2.57 suggests Nephros is potentially 45% undervalued
In this article we are going to estimate the intrinsic value of Nephros, Inc. (NASDAQ:NEPH) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Check out our latest analysis for Nephros
What's The Estimated Valuation?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$1.19m | US$1.65m | US$2.10m | US$2.51m | US$2.87m | US$3.19m | US$3.45m | US$3.67m | US$3.86m | US$4.02m |
Growth Rate Estimate Source | Est @ 53.29% | Est @ 37.97% | Est @ 27.24% | Est @ 19.74% | Est @ 14.48% | Est @ 10.80% | Est @ 8.23% | Est @ 6.43% | Est @ 5.16% | Est @ 4.28% |
Present Value ($, Millions) Discounted @ 8.2% | US$1.1 | US$1.4 | US$1.7 | US$1.8 | US$1.9 | US$2.0 | US$2.0 | US$2.0 | US$1.9 | US$1.8 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18m
After calculating the present value of future cash flows in the initial 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 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.2%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$4.0m× (1 + 2.2%) ÷ (8.2%– 2.2%) = US$69m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$69m÷ ( 1 + 8.2%)10= US$32m
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 US$49m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$2.6, the company appears quite undervalued at a 45% 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 Assumptions
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 Nephros 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 8.2%, which is based on a levered beta of 1.189. 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.
Moving On:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Nephros, there are three important factors you should look at:
Risks: To that end, you should be aware of the 1 warning sign we've spotted with Nephros .
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for NEPH's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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 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. 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.
