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IPH Limited (ASX:IPH) Shares Could Be 47% Below Their Intrinsic Value Estimate

Key Insights

  • IPH's estimated fair value is AU$13.28 based on 2 Stage Free Cash Flow to Equity

  • IPH is estimated to be 47% undervalued based on current share price of AU$7.00

  • Our fair value estimate is 41% higher than IPH's analyst price target of AU$9.39

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of IPH Limited (ASX:IPH) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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Check out our latest analysis for IPH

What's The Estimated Valuation?

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 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 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$36.3m

AU$121.4m

AU$130.0m

AU$143.6m

AU$153.8m

AU$162.4m

AU$169.8m

AU$176.3m

AU$182.2m

AU$187.7m

Growth Rate Estimate Source

Analyst x2

Analyst x2

Analyst x2

Analyst x1

Est @ 7.07%

Est @ 5.60%

Est @ 4.57%

Est @ 3.85%

Est @ 3.34%

Est @ 2.99%

Present Value (A$, Millions) Discounted @ 6.6%

AU$34.0

AU$107

AU$107

AU$111

AU$112

AU$111

AU$108

AU$106

AU$102

AU$99.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$997m

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 (2.2%) 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 6.6%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = AU$188m× (1 + 2.2%) ÷ (6.6%– 2.2%) = AU$4.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$4.3b÷ ( 1 + 6.6%)10= AU$2.3b

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$3.3b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$7.0, the company appears quite good value at a 47% 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
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 IPH 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 6.6%, which is based on a levered beta of 0.967. 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 IPH

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is well covered by earnings and cashflows.

Weakness

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

  • Shareholders have been diluted in the past year.

Opportunity

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

  • Trading below our estimate of fair value by more than 20%.

Threat

  • Dividends are not covered by earnings and cashflows.

  • Revenue is forecast to grow slower than 20% per year.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. 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 IPH, we've put together three pertinent elements you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with IPH (at least 1 which is a bit concerning) , and understanding these should be part of your investment process.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for IPH's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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.