Estimated fair value of CPS Technologies Corporation (NASDAQ:CPSH)
Today we are going to take a simple walkthrough of a valuation method used to estimate the attractiveness of CPS Technologies Corporation (NASDAQ:CPSH) as an investment opportunity by estimating the future cash flows of the company and discounting them to their current value. We will use the Discounted Cash Flow (DCF) model for this purpose. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
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.
What is the estimated valuation?
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To begin with, we need to obtain cash flow estimates for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest 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 discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF ($, millions)||$1.41m||$1.62 million||$1.79m||$1.93m||$2.05 million||$2.15 million||$2.24 million||$2.32 million||$2.39m||$2.45 million|
|Growth rate estimate Source||Is at 19.64%||East @ 14.34%||Is at 10.62%||Is at 8.02%||Is at 6.21%||Is at 4.93%||Is at 4.04%||Is at 3.42%||Is 2.98%||Is at 2.67%|
|Present value (millions of dollars) discounted at 6.9%||$1.3||$1.4||$1.5||$1.5||$1.5||$1.4||$1.4||$1.4||$1.3||$1.3|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $13 million
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 stage. 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 (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 6.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = $2.4 million × (1 + 2.0%) ÷ (6.9%–2.0%) = $51 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= $51m ÷ (1 + 6.9%)ten= $26 million
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $39 million. The final step is to divide the equity value by the number of shares outstanding. From the current share price of US$3.0, the company appears around fair value at the time of writing. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
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 consider CPS Technologies 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 6.9%, which is based on a leveraged beta of 1.125. 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.
Although a business valuation is important, it is only one of many factors you need to assess for a business. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For CPS Technologies, we have compiled three fundamental aspects to consider:
- Risks: For example, we have identified 3 warning signs for CPS Technologies of which you should be aware.
- 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!
- Other environmentally friendly businesses: Are you concerned about the environment and do you think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover actions you might not have thought of!
PS. The Simply Wall St app performs a daily updated cash flow assessment for each NASDAQCM stock. If you want to find the calculation for other stocks, search here.
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