Limited class intrinsic value estimate (ASX: CL1)
How far is Class Limited (ASX: CL1) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking expected future cash flows and discounting them to present value. One way to do this is to use the Discounted Cash Flow (DCF) model. 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.
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you would like to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St analysis model.
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The model
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”. To begin with, we need to estimate the next ten years of cash flow. 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 reported 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.
Typically, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Leverage FCF (A $, millions) | A $ 3.45M | A $ 7.90M | AU $ 10.3 million | A $ 10.6M | A $ 10.9M | A $ 11.2M | AU $ 11.5M | AU $ 11.8 million | A $ 12.0 million | AU $ 12.3 million |
Source of estimated growth rate | Analyst x2 | Analyst x2 | Analyst x2 | Is at 3.55% | Is 3.06% | Is 2.72% | Is 2.48% | Is 2.31% | Is 2.19% | Is 2.11% |
Present value (A $, millions) discounted at 6.4% | AU $ 3.2 | A $ 7.0 | AU $ 8.5 | AU $ 8.3 | AU $ 8.0 | A $ 7.7 | AU $ 7.4 | AU $ 7.1 | AU $ 6.9 | A $ 6.6 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 70 million Australian dollars
Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. 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 (1.9%) 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 6.4%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = A $ 12 million × (1 + 1.9%) ÷ (6.4% – 1.9%) = A $ 277 million
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= A $ 277 million ÷ (1 + 6.4%)^{ten}= A $ 148 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is A $ 218 million. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of AU $ 1.6, the company appears to have fair value at a discount of 9.6% from the current share price. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
The hypotheses
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. 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 Class 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 6.4%, which is based on a leveraged beta of 0.958. Beta is a measure of the volatility of a stock, relative to the overall market. 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.
Next steps:
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 equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. 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 the class, you need to explore three relevant elements:
- Risks: As an example, we found 2 warning signs for the class that you need to take into account before investing here.
- Management: Have insiders increased their stocks to take advantage of market sentiment for CL1’s future outlook? 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 ASX 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 stocks and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.
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