Estimating The Fair Value Of Transmetro Corporation Limited (ASX:TCO)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Transmetro fair value estimate is AU$1.82

• Current share price of AU$1.77 suggests Transmetro is potentially trading close to its fair value

• When compared to theindustry average discount to fair value of 7.7%, Transmetro's competitors seem to be trading at a greater discount

In this article we are going to estimate the intrinsic value of Transmetro Corporation Limited (ASX:TCO) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Transmetro

The Calculation

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$2.86m	AU$2.29m	AU$1.98m	AU$1.81m	AU$1.71m	AU$1.65m	AU$1.63m	AU$1.62m	AU$1.62m	AU$1.64m
Growth Rate Estimate Source	Est @ -29.68%	Est @ -20.13%	Est @ -13.44%	Est @ -8.76%	Est @ -5.49%	Est @ -3.19%	Est @ -1.59%	Est @ -0.46%	Est @ 0.32%	Est @ 0.87%
Present Value (A$, Millions) Discounted @ 8.6%	AU$2.6	AU$1.9	AU$1.5	AU$1.3	AU$1.1	AU$1.0	AU$0.9	AU$0.8	AU$0.8	AU$0.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$13m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$1.6m× (1 + 2.2%) ÷ (8.6%– 2.2%) = AU$26m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$26m÷ ( 1 + 8.6%)¹⁰= AU$11m

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$24m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$1.8, the company appears about fair value at a 2.8% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

Important 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Transmetro 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 8.6%, which is based on a levered beta of 1.392. 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 Transmetro

Strength

• Currently debt free.

Weakness

• Earnings declined over the past year.

Opportunity

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

• Lack of analyst coverage makes it difficult to determine TCO's earnings prospects.

Threat

• No apparent threats visible for TCO.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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 Transmetro, there are three pertinent items you should consider:

1. Risks: For instance, we've identified 3 warning signs for Transmetro (1 doesn't sit too well with us) you should be aware of.

2. 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!

3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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.