A look at the intrinsic value of Lycopodium Limited (ASX: LYL)
Today we are going to go over one way to estimate the intrinsic value of Lycopodium Limited (ASX: LYL) projecting its future cash flows and then discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
We have to calculate the value of Lycopodium slightly differently from other stocks because it is a construction company. In this approach, dividends per share (DPS) are used because free cash flow is difficult to estimate and often not reported by analysts. Unless a company pays out the majority of its FCF as a dividend, this method will generally underestimate the value of the stock. The “Gordon Growth Model” is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We then discount this figure to today’s value at a cost of equity of 8.0%. Compared to the current share price of AU $ 5.3, the company appears to be around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)
= AU $ 0.3 / (8.0% – 1.9%)
= AU $ 4.5
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 consider Lycopodium 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 takes debt into account. In this calculation, we used 8.0%, which is based on a leveraged beta of 1.289. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF is just one of the many factors you need to assess for a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Lycopodium, we have compiled three other aspects that you should consider:
Risks: We think you should evaluate the 1 warning sign for Lycopodium we reported before making an investment in the business.
Future benefits: How does LYL’s growth rate compare to its peers and the broader market? Deepen the number of analyst consensus for the coming years by interacting with our free chart of analysts’ growth expectations.
Other high quality alternatives: Do you like a good all-rounder? To explore our interactive list of high quality actions to get an idea of what else you might be missing!
PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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