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Is There An Opportunity With EDAG Engineering Group AG's (ETR:ED4) 49% Undervaluation?

Key Insights

In this article we are going to estimate the intrinsic value of EDAG Engineering Group AG (ETR:ED4) by taking the expected future cash flows and discounting them to today's value. This will be done using 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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See our latest analysis for EDAG Engineering Group

What's The Estimated Valuation?

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. To begin with, we have to get estimates of 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 (€, Millions)

€10.9m

€23.1m

€33.8m

€44.8m

€55.1m

€63.9m

€71.2m

€77.0m

€81.4m

€84.8m

Growth Rate Estimate Source

Analyst x1

Analyst x1

Est @ 46.35%

Est @ 32.55%

Est @ 22.89%

Est @ 16.13%

Est @ 11.39%

Est @ 8.08%

Est @ 5.76%

Est @ 4.14%

Present Value (€, Millions) Discounted @ 10%

€9.9

€19.0

€25.3

€30.4

€33.9

€35.8

€36.2

€35.5

€34.0

€32.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €292m

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 0.4%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = €85m× (1 + 0.4%) ÷ (10%– 0.4%) = €866m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €866m÷ ( 1 + 10%)10= €329m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €621m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of €12.6, the company appears quite undervalued at a 49% 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

Important Assumptions

Now 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 EDAG Engineering Group 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 10%, which is based on a levered beta of 1.965. 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 EDAG Engineering Group

Strength

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

  • Debt is well covered by earnings.

Weakness

  • Earnings growth over the past year underperformed the Auto Components industry.

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

Opportunity

  • Annual revenue is forecast to grow faster than the German market.

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

Threat

  • Debt is not well covered by operating cash flow.

  • Paying a dividend but company has no free cash flows.

  • Annual earnings are forecast to grow slower than the German market.

Moving On:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price sitting below the intrinsic value? For EDAG Engineering Group, there are three important items you should further research:

  1. Risks: Every company has them, and we've spotted 1 warning sign for EDAG Engineering Group you should know about.

  2. Future Earnings: How does ED4'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 XTRA 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.