Is LSI Industries Inc. (NASDAQ:LYTS) Trading At A 44% Discount?

Key Insights

• The projected fair value for LSI Industries is US$25.89 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$14.50 suggests LSI Industries is potentially 44% undervalued

• The US$18.67 analyst price target for LYTS is 28% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of LSI Industries Inc. (NASDAQ:LYTS) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

View our latest analysis for LSI Industries

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$29.1m	US$38.4m	US$41.3m	US$43.8m	US$45.9m	US$47.8m	US$49.5m	US$51.0m	US$52.5m	US$53.9m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 7.61%	Est @ 5.99%	Est @ 4.86%	Est @ 4.07%	Est @ 3.51%	Est @ 3.13%	Est @ 2.85%	Est @ 2.66%
Present Value ($, Millions) Discounted @ 7.9%	US$27.0	US$33.0	US$32.9	US$32.3	US$31.4	US$30.3	US$29.1	US$27.8	US$26.5	US$25.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$295m

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$54m× (1 + 2.2%) ÷ (7.9%– 2.2%) = US$970m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$970m÷ ( 1 + 7.9%)¹⁰= US$453m

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$749m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$14.5, the company appears quite undervalued at a 44% 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.

dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 LSI Industries 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 7.9%, which is based on a levered beta of 1.136. 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.

SWOT Analysis for LSI Industries

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Electrical industry.

• Dividend is low compared to the top 25% of dividend payers in the Electrical market.

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual revenue is forecast to grow slower than the American market.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For LSI Industries, there are three further items you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with LSI Industries , and understanding this should be part of your investment process.

2. Future Earnings: How does LYTS'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.

3. 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!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.