Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Senetas Corporation Limited (ASX:SEN) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today’s value. This is done using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.
Step by step through the calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
|Levered FCF (A$, Millions)||A$5.30||A$6.10||A$6.90||A$7.89||A$9.02|
|Source||Analyst x1||Analyst x1||Analyst x1||Est @ 14.33%||Est @ 14.33%|
|Present Value Discounted @ 9.18%||A$4.85||A$5.12||A$5.30||A$5.55||A$5.81|
Present Value of 5-year Cash Flow (PVCF)= AU$27m
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today’s value at a cost of equity of 9.2%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = AU$9m × (1 + 2.8%) ÷ (9.2% – 2.8%) = AU$145m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$145m ÷ ( 1 + 9.2%)5 = AU$93m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$120m. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of A$0.11. Compared to the current share price of A$0.10, the stock is about right, perhaps slightly undervalued at a 9.8% discount to what it is available for right now.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Senetas as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 9.2%, which is based on a levered beta of 0.886. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. For SEN, there are three pertinent aspects you should look at:
- Financial Health: Does SEN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does SEN’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of SEN? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every AU stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.