Calculating The Fair Value Of essensys plc (LON:ESYS)

Key Insights

• The projected fair value for essensys is UK£0.33 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£0.28 suggests essensys is potentially trading close to its fair value

• essensys' peers seem to be trading at a lower discount to fair value based onthe industry average of 8.2%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of essensys plc (LON:ESYS) 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for essensys

Crunching The Numbers

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. To start off with, we need to estimate the next ten years of cash flows. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	-UK£5.95m	UK£461.5k	UK£711.1k	UK£984.1k	UK£1.25m	UK£1.50m	UK£1.72m	UK£1.90m	UK£2.05m	UK£2.17m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 54.08%	Est @ 38.39%	Est @ 27.40%	Est @ 19.71%	Est @ 14.33%	Est @ 10.56%	Est @ 7.92%	Est @ 6.08%
Present Value (£, Millions) Discounted @ 7.4%	-UK£5.5	UK£0.4	UK£0.6	UK£0.7	UK£0.9	UK£1.0	UK£1.0	UK£1.1	UK£1.1	UK£1.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.3m

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£2.2m× (1 + 1.8%) ÷ (7.4%– 1.8%) = UK£39m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£39m÷ ( 1 + 7.4%)¹⁰= UK£19m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£21m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.3, the company appears about fair value at a 16% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

The 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 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 essensys 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 7.4%, which is based on a levered beta of 1.029. 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 essensys

Strength

• Currently debt free.

Weakness

• No major weaknesses identified for ESYS.

Opportunity

• Current share price is below our estimate of fair value.

Threat

• Has less than 3 years of cash runway based on current free cash flow.

Next Steps:

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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 essensys, there are three pertinent items you should look at:

1. Risks: For example, we've discovered 4 warning signs for essensys (3 are a bit unpleasant!) that you should be aware of before investing here.

2. Future Earnings: How does ESYS'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 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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.