Are Investors Undervaluing Ultra Electronics Holdings plc (LON:ULE) By 21%?
Does the April share price for Ultra Electronics Holdings plc (LON:ULE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. I will use the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
See our latest analysis for Ultra Electronics Holdings
Crunching the numbers
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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | |
Levered FCF (£, Millions) | UK£71.6m | UK£79.3m | UK£97.7m | UK£104.2m | UK£109.3m | UK£113.1m | UK£116.1m | UK£118.4m | UK£120.3m | UK£121.8m |
Growth Rate Estimate Source | Analyst x4 | Analyst x6 | Analyst x4 | Est @ 6.66% | Est @ 4.82% | Est @ 3.54% | Est @ 2.63% | Est @ 2% | Est @ 1.56% | Est @ 1.25% |
Present Value (£, Millions) Discounted @ 6.7% | UK£67.1 | UK£69.7 | UK£80.4 | UK£80.4 | UK£79.0 | UK£76.7 | UK£73.7 | UK£70.5 | UK£67.1 | UK£63.7 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£728m
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 0.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.7%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£122m× (1 + 0.5%) ÷ 6.7%– 0.5%) = UK£2.0b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£2.0b÷ ( 1 + 6.7%)10= UK£1.0b
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£1.8b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£19.7, the company appears a touch undervalued at a 21% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Important assumptions
Now 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 Ultra Electronics Holdings 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 6.7%, which is based on a levered beta of 1.017. 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.
Next Steps:
Although the valuation of a company is important, 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 Ultra Electronics Holdings, We've put together three fundamental factors you should look at:
Risks: You should be aware of the 1 warning sign for Ultra Electronics Holdings we've uncovered before considering an investment in the company.
Future Earnings: How does ULE'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. Simply Wall St updates its DCF calculation for every GB stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.
