Are investors undervaluing Science Group plc (LON:SAG) by 23%?

Key insights

Today we will discuss a way to estimate the intrinsic value of Science Group plc (LON:SAG) by taking its expected future cash flows and discounting them to today’s value. One way to achieve this is by using the Discounted Cash Flow (DCF) model. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you might think.

However, remember that there are many ways to estimate a company’s value, and a DCF is just one method. If you want to learn more about discounted cash flow, you can read the reasoning behind this calculation in detail in the Simply Wall St analysis model.

See our latest analysis for Science Group

Step by step through the calculation

We use what is called a two-phase model, which simply means that we have two different growth periods for the company’s cash flows. Generally, the first stage is higher growth and the second stage is lower growth. To start, we need to estimate cash flows for the next ten years. Where possible we use analyst estimates, but if these are not available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to reflect that growth typically slows more in the early years than in later years.

We generally assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:

Free cash flow (FCF) estimate over 10 years

(“Est” = FCF growth rate estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = UK £112 million

The second phase is also called Terminal Value, which is the company’s cash flow after the first phase. 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 five-year average of the ten-year government bond yield (1.6%) to estimate future growth. In the same way as the 10-year ‘growth’ period, we discount future cash flows to present value, using the 6.5% cost of equity.

The story continues

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£12 million × (1 + 1.6%) ÷ (6.5% – 1.6%) = UK£251 million

Current Value of Final Value (PVTV)= TV / (1 + r)¹⁰= UK£251m ÷ ( 1 + 6.5%)¹⁰= UK £133 million

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£246 million. In the last step we divide the share value by the number of shares outstanding. Compared to the current share price of £4.2, the company looks a touch undervalued, at a 23% discount to where the share price is currently trading. However, valuations are imprecise instruments, much like a telescope: move a few degrees and you end up in another galaxy. Keep this in mind.

The assumptions

The above calculation is highly dependent on two assumptions. The first is the discount rate and the other is the cash flows. You do not have to agree with this entry. I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the potential cyclicality of an industry, or a company’s future capital requirements, and thus does not provide a complete picture of a company’s potential performance. Since we consider Science Group 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 6.5%, based on a levered beta of 0.894. Beta is a measure of a stock’s volatility compared to the market as a whole. We take 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 company.

SWOT Analysis for Science Group

power

Weakness

Possibility

Threat

To proceed:

While important, the DCF calculation will ideally not be the only piece of analysis you scrutinize for a company. The DCF model is not a perfect tool for valuing shares. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different pace, or if the cost of equity or risk-free rate changes significantly, the outcome can be very different. Can we figure out why the company is trading at a discount to intrinsic value? For Science Group, there are three relevant elements to investigate:

1. Risks: For example, consider the ever-present specter of investment risk. We have identified 1 warning sign with Science Group, and understanding it should be part of your investment process.

2. Future earnings: How does SAG’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by using our free analyst growth forecast chart.

3. Other solid companies: Low debt, high returns on equity and good past performance are fundamental to a strong company. Explore our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

P.S. Simply Wall St updates the DCF calculation for every UK share every day, so if you want to find the intrinsic value of another share, just search here.

Do you have feedback on this article? Worried about the content? Please contact us directly from us. You can also email the editorial team (at) Simplywallst.com.

This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. We aim to provide you with targeted, long-term analysis based on fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no positions in the stocks mentioned.