Does the December share price for Imdex Limited (ASX: IMD) reflect its true value? Today we’re going to estimate the intrinsic value of the stock by taking expected future cash flows and discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business and that a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should read the Simply Wall St.

Check out our latest analysis for Imdex

The method

We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To start with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = AU $ 469 million

The second stage is also known as 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 that 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 (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.6%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU $ 91 million × (1 + 1.9%) ÷ (6.6% – 1.9%) = AU $ 1.9 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= AU $ 1.9 billion ÷ (1 + 6.6%)^ten= 1.0 billion Australian dollars

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is AU $ 1.5 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of AU $ 2.9, the company appears to be slightly undervalued with a 22% discount to the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

We draw your attention to the fact 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 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 full picture of a company’s potential performance. Since we view Imdex 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 6.6%, which is based on a leveraged beta of 1.087. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Next steps:

While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect stock assessment tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. 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. Can we understand why the company trades at a discount to its intrinsic value? For Imdex, we have compiled three essential aspects that you need to evaluate:

1. Risks: Concrete example, we have spotted 1 warning sign for Imdex you must be aware.
2. Management: Have insiders increased their stocks to take advantage of market sentiment about IMD’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!

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.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 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 documents. Simply Wall St has no position in any of the stocks mentioned.