How far off is EKF Diagnostics Holdings plc (LON:EKF) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing 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'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for EKF Diagnostics Holdings

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't 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 see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (£, Millions)  UK£9.99m UK£12.9m UK£16.3m UK£17.7m UK£18.7m UK£19.5m UK£20.1m UK£20.6m UK£21.1m UK£21.4m Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Analyst x1 Est @ 5.6% Est @ 4.22% Est @ 3.25% Est @ 2.57% Est @ 2.1% Est @ 1.77% Present Value (£, Millions) Discounted @ 5.7%  UK£9.4 UK£11.5 UK£13.8 UK£14.2 UK£14.1 UK£13.9 UK£13.6 UK£13.2 UK£12.7 UK£12.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£128m



The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 have used the 5-year average of the 10-year government bond yield (1.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 5.7%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£21m× (1 + 1.0%) ÷ (5.7%– 1.0%) = UK£455m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£455m÷ ( 1 + 5.7%)10= UK£260m

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£388m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.4, the company appears quite good value at a 49% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out. dcf

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at EKF Diagnostics Holdings 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 accounts for debt. In this calculation we've used 5.7%, which is based on a levered beta of 0.891. Beta is a measure of a stock's volatility, compared 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.

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For EKF Diagnostics Holdings, we've compiled three further elements you should further research:

Risks: We feel that you should assess the 2 warning signs for EKF Diagnostics Holdings we've flagged before making an investment in the company. Future Earnings: How does EKF's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart. Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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