Using the 2 Stage Free Cash Flow to Equity, Spectra Systems fair value estimate is UK£2.13
Current share price of UK£1.66 suggests Spectra Systems is potentially 22% undervalued
Peers of Spectra Systems are currently trading on average at a 32% premium
Does the September share price for Spectra Systems Corporation (LON:SPSY) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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)
US$6.80m
US$6.76m
US$6.75m
US$6.78m
US$6.82m
US$6.88m
US$6.95m
US$7.03m
US$7.12m
US$7.21m
Growth Rate Estimate Source
Est @ -1.58%
Est @ -0.69%
Est @ -0.07%
Est @ 0.36%
Est @ 0.67%
Est @ 0.88%
Est @ 1.03%
Est @ 1.14%
Est @ 1.21%
Est @ 1.26%
Present Value ($, Millions) Discounted @ 6.8%
US$6.4
US$5.9
US$5.5
US$5.2
US$4.9
US$4.6
US$4.4
US$4.2
US$3.9
US$3.7
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$49m
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 1.4%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$135m÷ ( 1 + 6.8%)10= US$70m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$119m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.7, the company appears a touch undervalued at a 22% 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.
AIM:SPSY Discounted Cash Flow September 17th 2023
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. 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 Spectra Systems 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 6.8%, which is based on a levered beta of 1.080. 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 Spectra Systems
Strength
Earnings growth over the past year exceeded the industry.
Currently debt free.
Dividends are covered by earnings and cash flows.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Electronic market.
Opportunity
Annual earnings are forecast to grow faster than the British market.
Good value based on P/E ratio and estimated fair value.
Threat
No apparent threats visible for SPSY.
Moving On:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Spectra Systems, we've compiled three fundamental factors you should explore:
Future Earnings: How does SPSY'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 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 British stock every day, so if you want to find the intrinsic value of any other stock 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.
