Today we’re going to review one way to estimate the intrinsic value of Crimson Tide plc (LON: TIDE) by taking expected future cash flows and discounting them to present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

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Is Crimson Tide Valued Enough?

We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for 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 latest estimate or stated 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 down more in the early years than in subsequent 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) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 2.0million in UK

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. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.9%. We discount the terminal cash flows to their present value at a cost of equity of 5.9%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = UK £ 2.1m × (1 + 0.9%) ÷ (5.9% –0.9%) = UK £ 42m

Present value of terminal value (PVTV)= TV / (1 + r)^ten= United Kingdom £ 42m UK (1 + 5.9%)^ten= £ 24 million in the UK

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £ 26million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £ 0.03 UK, the company is shown at fair value at a 17% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play 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 full picture of a company’s potential performance. Since we view Crimson Tide 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 into account debt. In this calculation, we used 5.9%, which is based on a leveraged beta of 0.938. 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 from globally comparable companies, with a limit imposed 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 it’s just one of the many factors you need to evaluate for a business. The DCF model is not a perfect inventory valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Crimson Tide, we’ve compiled three relevant aspects that you should dig deeper into:

1. Risks: We think you should evaluate the 2 warning signs for Crimson Tide we reported before making an investment in the business.
2. Future income: How does TIDE’s growth rate compare to its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
3. Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each AIM share. If you want to find the calculation for other actions, just search here.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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