Does Dialight plc (LON:DIA) share price in April reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to their present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!

We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.

See our latest review for Dialight

The model

We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £80 million

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.4%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = £18 million × (1 + 0.9%) ÷ (7.4%–0.9%) = £283 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= UK £283 million ÷ (1 + 7.4%)^ten= UK £139 million

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £219 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £3.7 in the UK, the company appears to be pretty good value at a 45% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

We emphasize 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 entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Dialight 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 factors in debt. In this calculation, we used 7.4%, which is based on a leveraged beta of 1.343. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Look forward:

Although the valuation of a business is important, it will ideally not be the only piece of analysis you will look at for a business. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of 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, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is intrinsic value higher than the current stock price? For Dialight, we’ve compiled three fundamentals you should explore:

1. Risks: For example, we discovered 1 warning sign for Dialight which you should be aware of before investing here.
2. Management:Did insiders increase their shares to take advantage of market sentiment about DIA’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
3. Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of ​​what you might be missing!

PS. Simply Wall St updates its DCF calculation for every UK stock daily, so if you want to find the intrinsic value of any other stock, just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.