Is There An Opportunity With DDH1 Limited's (ASX:DDH) 23% Undervaluation?

Key Insights

• DDH1's estimated fair value is AU$1.14 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$0.88 suggests DDH1 is potentially 23% undervalued

• Analyst price target for DDH is AU$0.95 which is 17% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of DDH1 Limited (ASX:DDH) 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for DDH1

The Model

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$45.0m	AU$46.3m	AU$32.0m	AU$29.8m	AU$28.5m	AU$27.9m	AU$27.6m	AU$27.5m	AU$27.7m	AU$28.0m
Growth Rate Estimate Source	Analyst x1	Analyst x2	Analyst x1	Est @ -6.88%	Est @ -4.21%	Est @ -2.35%	Est @ -1.04%	Est @ -0.12%	Est @ 0.52%	Est @ 0.96%
Present Value (A$, Millions) Discounted @ 8.0%	AU$41.7	AU$39.7	AU$25.4	AU$21.9	AU$19.4	AU$17.6	AU$16.1	AU$14.9	AU$13.9	AU$13.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$224m

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$28m× (1 + 2.0%) ÷ (8.0%– 2.0%) = AU$478m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$478m÷ ( 1 + 8.0%)¹⁰= AU$222m

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$446m. 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$0.9, the company appears a touch undervalued at a 23% 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

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. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 DDH1 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 8.0%, which is based on a levered beta of 1.193. 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 DDH1

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year is below its 5-year average.

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

Opportunity

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

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

Threat

• Annual revenue is forecast to grow slower than the Australian market.

Looking Ahead:

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. 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For DDH1, we've compiled three important elements you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with DDH1 , and understanding it should be part of your investment process.

2. Future Earnings: How does DDH'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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.