Today we'll do a simple run through of a valuation method used to estimate the attractiveness of hVIVO plc (LON:HVO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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.
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. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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) estimate
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
Levered FCF (£, Millions)
UK£4.40m
UK£5.07m
UK£5.56m
UK£5.95m
UK£6.26m
UK£6.52m
UK£6.72m
UK£6.90m
UK£7.04m
UK£7.17m
Growth Rate Estimate Source
Analyst x3
Analyst x2
Est @ 9.55%
Est @ 7.03%
Est @ 5.27%
Est @ 4.03%
Est @ 3.17%
Est @ 2.56%
Est @ 2.14%
Est @ 1.84%
Present Value (£, Millions) Discounted @ 7.5%
UK£4.1
UK£4.4
UK£4.5
UK£4.5
UK£4.4
UK£4.2
UK£4.1
UK£3.9
UK£3.7
UK£3.5
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = UK£41m
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. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£114m÷ ( 1 + 7.5%)10= UK£55m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£96m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.2, the company appears potentially overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
AIM:HVO Discounted Cash Flow March 8th 2023
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 hVIVO 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 7.5%, which is based on a levered beta of 0.912. 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 hVIVO
Strength
Debt is well covered by cash flow.
Weakness
Interest payments on debt are not well covered.
Expensive based on P/S ratio and estimated fair value.
Opportunity
Expected to breakeven next year.
Has sufficient cash runway for more than 3 years based on current free cash flows.
Threat
No apparent threats visible for HVO.
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. 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. Why is the intrinsic value lower than the current share price? For hVIVO, we've put together three important items you should consider:
Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with hVIVO , and understanding it should be part of your investment process.
Future Earnings: How does HVO'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.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM 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.
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