Does this assessment by IPG Photonics Corporation (NASDAQ: IPGP) imply that investors are paying too much?
In this article, we’ll estimate the intrinsic value of IPG Photonics Corporation (NASDAQ: IPGP) by taking expected future cash flows and discounting them to present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are easy enough to follow.
There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Discover our latest analyzes for IPG photonics
The calculation
We are going to use a two-step DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. First, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last published value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the 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 the present value:
10-year Free Cash Flow (FCF) forecast
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | $ 187.4 million | $ 293.1 million | $ 301.4 million | $ 344.2 million | $ 416.9 million | $ 455.0 million | 486.9 million USD | $ 513.6 million | $ 536.4 million | $ 556.3 million |
Source of estimated growth rate | Analyst x3 | Analyst x3 | Analyst x2 | Analyst x1 | Analyst x1 | Is 9.15% | Is at 7% | Is 5.5% | Is 4.44% | Is 3.71% |
Present value ($, millions) discounted at 7.4% | US $ 175 | US $ 254 | US $ 243 | US $ 259 | US $ 292 | US $ 297 | US $ 295 | US $ 290 | US $ 282 | US $ 273 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 2.7 billion USD
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. For a number of reasons, a very conservative growth rate is used that 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 (2.0%) 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)= FCF_{2030} × (1 + g) ÷ (r – g) = $ 556 million × (1 + 2.0%) ÷ (7.4% – 2.0%) = $ 10 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= 10 billion USD ÷ (1 + 7.4%)^{ten}= 5.1 billion USD
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 7.8 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 196, the company appears reasonably expensive at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
The hypotheses
Now the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 IPG Photonics 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 takes debt into account. In this calculation, we used 7.4%, which is based on a leveraged beta of 1.145. Beta is a measure of the volatility of a stock, relative 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.
To move on:
Valuation is only one side of the coin in terms of building your investment thesis, and ideally it won’t be the only analysis you look at for a business. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see how they would impact the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. What is the reason why the stock price exceeds intrinsic value? For IPG photonics, you need to look at three relevant things:
- Risks: Take, for example, the ubiquitous spectrum of investment risk. We have identified 2 warning signs with IPG Photonics, and understanding them should be part of your investment process.
- Management: Have Insiders Raised Their Shares To Take Advantage Of Market Sentiment For The Future Outlook Of IPGP? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.
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