Dropsuite Limited's (ASX:DSE) Intrinsic Value Is Potentially 19% Below Its Share Price

Key Insights

• Dropsuite's estimated fair value is AU$0.18 based on 2 Stage Free Cash Flow to Equity

• Dropsuite's AU$0.23 share price signals that it might be 24% overvalued

• When compared to theindustry average discount of -50%, Dropsuite's competitors seem to be trading at a greater premium to fair value

Does the March share price for Dropsuite Limited (ASX:DSE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

View our latest analysis for Dropsuite

Is Dropsuite Fairly Valued?

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (A$, Millions)	AU$1.65m	AU$3.10m	AU$3.50m	AU$4.60m	AU$6.30m	AU$7.42m	AU$8.38m	AU$9.19m	AU$9.86m	AU$10.4m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ 17.71%	Est @ 12.98%	Est @ 9.66%	Est @ 7.34%	Est @ 5.72%
Present Value (A$, Millions) Discounted @ 7.8%	AU$1.5	AU$2.7	AU$2.8	AU$3.4	AU$4.3	AU$4.7	AU$5.0	AU$5.0	AU$5.0	AU$4.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$39m

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 (1.9%) 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 7.8%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = AU$10m× (1 + 1.9%) ÷ (7.8%– 1.9%) = AU$181m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$181m÷ ( 1 + 7.8%)¹⁰= AU$86m

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 AU$125m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.2, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The Assumptions

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. 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 Dropsuite 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 7.8%, which is based on a levered beta of 0.986. 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 Dropsuite

Strength

• Currently debt free.

Weakness

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• Annual earnings are forecast to grow faster than the Australian market.

Threat

• No apparent threats visible for DSE.

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize 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. What is the reason for the share price exceeding the intrinsic value? For Dropsuite, we've compiled three essential aspects you should further examine:

1. Risks: You should be aware of the 1 warning sign for Dropsuite we've uncovered before considering an investment in the company.

2. Future Earnings: How does DSE'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks 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.

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