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Is There An Opportunity With IPH Limited's (ASX:IPH) 22% Undervaluation?

Simply Wall St

Today we will run through one way of estimating the intrinsic value of IPH Limited (ASX:IPH) by taking the expected future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

Check out our latest analysis for IPH

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 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (A$, Millions) AU$74.1m AU$96.9m AU$100.3m AU$102.9m AU$105.0m AU$106.9m AU$108.6m AU$110.2m AU$111.6m AU$113.0m
Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Est @ 2.55% Est @ 2.11% Est @ 1.8% Est @ 1.58% Est @ 1.43% Est @ 1.33% Est @ 1.25%
Present Value (A$, Millions) Discounted @ 6.1% AU$69.8 AU$86.1 AU$84.0 AU$81.2 AU$78.1 AU$75.0 AU$71.8 AU$68.6 AU$65.6 AU$62.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$742m

After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.1%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = AU$113m× (1 + 1.1%) ÷ 6.1%– 1.1%) = AU$2.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$2.3b÷ ( 1 + 6.1%)10= AU$1.3b

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$2.0b. 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$7.3, the company appears a touch undervalued at a 22% 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.

ASX:IPH Intrinsic value, March 17th 2020

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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 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 6.1%, which is based on a levered beta of 0.921. 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.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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 to differ from the intrinsic value? For IPH, We've compiled three important aspects you should look at:

  1. Risks: For example, we've discovered 3 warning signs for IPH that you should be aware of before investing here.
  2. Future Earnings: How does IPH'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 AU stock every day, so if you want to find the intrinsic value of any other stock just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.