How far off is IDOX plc (LON:IDOX) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them 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.
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. 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
|Levered FCF (£, Millions)||UK£9.95m||UK£12.5m||UK£14.5m||UK£15.7m||UK£16.6m||UK£17.4m||UK£18.0m||UK£18.5m||UK£18.9m||UK£19.3m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Analyst x2||Est @ 8.06%||Est @ 6.01%||Est @ 4.57%||Est @ 3.57%||Est @ 2.86%||Est @ 2.37%||Est @ 2.02%|
|Present Value (£, Millions) Discounted @ 8.8%||UK£9.1||UK£10.6||UK£11.3||UK£11.2||UK£10.9||UK£10.5||UK£10.0||UK£9.4||UK£8.9||UK£8.3|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£100m
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 10-year government bond rate of 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£19m× (1 + 1.2%) ÷ 8.8%– 1.2%) = UK£258m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£258m÷ ( 1 + 8.8%)10= UK£111m
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£211m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.4, the company appears about fair value at a 6.4% discount to where the stock price trades currently. 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.
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 IDOX 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 8.8%, which is based on a levered beta of 1.095. 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 IDOX, We've compiled three relevant aspects you should look at:
- Risks: Every company has them, and we've spotted 5 warning signs for IDOX (of which 2 shouldn't be ignored!) you should know about.
- Future Earnings: How does IDOX'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 AIM 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.