Technology One Limited's (ASX:TNE) Intrinsic Value Is Potentially 23% Below Its Share Price

Key Insights

• Technology One's estimated fair value is AU$12.08 based on 2 Stage Free Cash Flow to Equity

• Technology One's AU$15.78 share price signals that it might be 31% overvalued

• The AU$16.29 analyst price target for TNE is 35% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Technology One Limited (ASX:TNE) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Technology One

Step By Step Through The Calculation

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.

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$129.7m	AU$155.8m	AU$176.7m	AU$239.1m	AU$233.8m	AU$231.8m	AU$231.9m	AU$233.5m	AU$236.0m	AU$239.3m
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x6	Analyst x3	Analyst x2	Est @ -0.82%	Est @ 0.05%	Est @ 0.66%	Est @ 1.08%	Est @ 1.38%
Present Value (A$, Millions) Discounted @ 7.0%	AU$121	AU$136	AU$144	AU$182	AU$166	AU$154	AU$144	AU$136	AU$128	AU$121

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.4b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$239m× (1 + 2.1%) ÷ (7.0%– 2.1%) = AU$4.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$4.9b÷ ( 1 + 7.0%)¹⁰= AU$2.5b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$3.9b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$15.8, the company appears potentially overvalued at the time of writing. 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

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 Technology One 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 7.0%, which is based on a levered beta of 0.991. 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 Technology One

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

Weakness

• Earnings growth over the past year is below its 5-year average.

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

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

Opportunity

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

Threat

• Revenue is forecast to grow slower than 20% per year.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for 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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a premium to intrinsic value? For Technology One, we've put together three pertinent factors you should further research:

1. Risks: Case in point, we've spotted 1 warning sign for Technology One you should be aware of.

2. Future Earnings: How does TNE'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX 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.