Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Iconovo AB (publ) (STO:ICO) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Check out our latest analysis for Iconovo
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. 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, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (SEK, Millions)||-kr2.5m||kr5.50m||kr8.78m||kr12.5m||kr16.1m||kr19.5m||kr22.4m||kr24.7m||kr26.5m||kr28.0m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 59.7%||Est @ 41.93%||Est @ 29.5%||Est @ 20.8%||Est @ 14.71%||Est @ 10.44%||Est @ 7.46%||Est @ 5.37%|
|Present Value (SEK, Millions) Discounted @ 5.8%||-kr2.4||kr4.9||kr7.4||kr9.9||kr12.2||kr13.9||kr15.0||kr15.7||kr15.9||kr15.9|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = kr108m
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 (0.5%) 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 5.8%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = kr28m× (1 + 0.5%) ÷ (5.8%– 0.5%) = kr526m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= kr526m÷ ( 1 + 5.8%)10= kr299m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is kr407m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of kr57.0, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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. 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 Iconovo 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 5.8%, which is based on a levered beta of 0.889. 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.
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It’s not possible to obtain a foolproof valuation with a DCF model. 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 Iconovo, there are three important factors you should consider:
- Risks: For instance, we’ve identified 3 warning signs for Iconovo that you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for ICO’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 OM 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.
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