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Are Investors Undervaluing COSOL Limited (ASX:COS) By 48%?

Key Insights

  • COSOL's estimated fair value is AU$1.61 based on 2 Stage Free Cash Flow to Equity

  • Current share price of AU$0.84 suggests COSOL is potentially 48% undervalued

  • The average premium for COSOL's competitorsis currently 109%

In this article we are going to estimate the intrinsic value of COSOL Limited (ASX:COS) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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 COSOL

Is COSOL Fairly Valued?

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (A$, Millions)

AU$10.1m

AU$10.1m

AU$11.6m

AU$12.3m

AU$14.2m

AU$15.4m

AU$16.3m

AU$17.2m

AU$17.9m

AU$18.5m

Growth Rate Estimate Source

Analyst x1

Analyst x2

Analyst x2

Analyst x1

Analyst x1

Est @ 8.18%

Est @ 6.35%

Est @ 5.07%

Est @ 4.17%

Est @ 3.54%

Present Value (A$, Millions) Discounted @ 7.2%

AU$9.4

AU$8.8

AU$9.4

AU$9.3

AU$10.0

AU$10.1

AU$10.1

AU$9.9

AU$9.6

AU$9.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$96m

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 (2.1%) 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 7.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = AU$19m× (1 + 2.1%) ÷ (7.2%– 2.1%) = AU$370m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$370m÷ ( 1 + 7.2%)10= AU$185m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$281m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$0.8, the company appears quite undervalued at a 48% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
dcf

The Assumptions

Now 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 COSOL 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 7.2%, which is based on a levered beta of 1.021. 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 COSOL

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is not viewed as a risk.

Weakness

  • Dividend is low compared to the top 25% of dividend payers in the Software market.

  • Shareholders have been diluted in the past year.

Opportunity

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

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

  • Significant insider buying over the past 3 months.

Threat

  • Dividends are not covered by cash flow.

Next Steps:

Although the valuation of a company is important, it 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For COSOL, we've compiled three relevant elements you should assess:

  1. Risks: Every company has them, and we've spotted 3 warning signs for COSOL you should know about.

  2. Future Earnings: How does COS'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.