A Look At The Fair Value Of INOVIQ Ltd (ASX:IIQ)

Key Insights

• INOVIQ's estimated fair value is AU$0.60 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$0.57 suggests INOVIQ is potentially trading close to its fair value

• Industry average discount to fair value of 36% suggests INOVIQ's peers are currently trading at a higher discount

Does the March share price for INOVIQ Ltd (ASX:IIQ) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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 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 INOVIQ

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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	-AU$7.70m	-AU$3.90m	AU$900.0k	AU$1.32m	AU$1.76m	AU$2.18m	AU$2.56m	AU$2.89m	AU$3.17m	AU$3.40m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 46.66%	Est @ 33.31%	Est @ 23.97%	Est @ 17.42%	Est @ 12.84%	Est @ 9.64%	Est @ 7.40%
Present Value (A$, Millions) Discounted @ 5.8%	-AU$7.3	-AU$3.5	AU$0.8	AU$1.1	AU$1.3	AU$1.6	AU$1.7	AU$1.8	AU$1.9	AU$1.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.3m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 5.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$3.4m× (1 + 2.2%) ÷ (5.8%– 2.2%) = AU$94m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$94m÷ ( 1 + 5.8%)¹⁰= AU$54m

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$55m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$0.6, the company appears about fair value at a 4.4% 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

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. 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 INOVIQ 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 5.8%, which is based on a levered beta of 0.800. 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 INOVIQ

Strength

• Currently debt free.

Weakness

• No major weaknesses identified for IIQ.

Opportunity

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

Threat

• Has less than 3 years of cash runway based on current free cash flow.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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. For INOVIQ, we've compiled three essential items you should further research:

1. Risks: Every company has them, and we've spotted 4 warning signs for INOVIQ (of which 1 is a bit unpleasant!) you should know about.

2. Future Earnings: How does IIQ'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.