Does the July share price for Elmo Software Limited (ASX:ELO) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you want to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St Analysis Template.
See our latest review for Elmo Software
The method
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF (A$, Millions) | -A$4.07 million | AU$4.27 million | A$7.46 million | AU$11.4 million | A$15.7 million | A$19.9 million | AU$23.8 million | AU$27.2 million | A$30.0 million | AU$32.3 million |
Growth rate estimate Source | Analyst x4 | Analyst x3 | Is at 74.89% | Is 52.98% | East @ 37.63% | Is at 26.89% | Is at 19.37% | Is at 14.11% | Is at 10.43% | Is at 7.85% |
Present value (A$, millions) discounted at 6.6% | -AU$3.8 | AU$3.8 | AU$6.2 | AU$8.8 | AU$11.4 | AU$13.6 | AU$15.2 | AU$16.3 | AU$16.9 | AU$17.1 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = AU$105 million
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.8%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.6%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = AU$32 million × (1 + 1.8%) ÷ (6.6%–1.8%) = AU$690 million
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= AU$690m÷ ( 1 + 6.6%)^{ten}= AU$364 million
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is A$469 million. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.8, the company appears to be pretty good value with a 47% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Elmo Software 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 factors in debt. In this calculation, we used 6.6%, which is based on a leveraged beta of 1.126. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
While important, the DCF calculation will ideally not be the only piece of analysis you look at for a business. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is the stock price below intrinsic value? For Elmo Software, there are three additional factors you should dig into:
- Risks: For example, we discovered 1 warning sign for Elmo Software which you should be aware of before investing here.
- Future earnings: How does ELO’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. Simply Wall St updates its DCF calculation for every Australian stock daily, so if you want to find the intrinsic value of any other stock, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.