Key Insights

Using the 2 Stage Free Cash Flow to Equity, Gooch & Housego fair value estimate is UK£9.15 Gooch & Housego is estimated to be 35% undervalued based on current share price of UK£5.98 The UK£7.80 analyst price target for GHH is 15% less than our estimate of fair value

How far off is Gooch & Housego PLC (LON:GHH) 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. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Gooch & Housego

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 Levered FCF (£, Millions)  UK£7.23m UK£11.0m UK£14.0m UK£16.7m UK£19.0m UK£20.9m UK£22.5m UK£23.7m UK£24.7m UK£25.6m Growth Rate Estimate Source Analyst x4 Analyst x4 Est @ 27.07% Est @ 19.32% Est @ 13.90% Est @ 10.10% Est @ 7.44% Est @ 5.58% Est @ 4.28% Est @ 3.37% Present Value (£, Millions) Discounted @ 9.5%  UK£6.6 UK£9.2 UK£10.6 UK£11.6 UK£12.0 UK£12.1 UK£11.9 UK£11.4 UK£10.9 UK£10.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£107m

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 (1.2%) 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 9.5%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£26m× (1 + 1.2%) ÷ (9.5%– 1.2%) = UK£312m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£312m÷ ( 1 + 9.5%)10= UK£126m

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£232m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£6.0, the company appears quite good value at a 35% 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Gooch & Housego 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 9.5%, which is based on a levered beta of 1.190. 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.

SWOT Analysis for Gooch & Housego

Strength

Debt is not viewed as a risk.

Weakness

Dividend is low compared to the top 25% of dividend payers in the Electronic market.

Opportunity

Expected to breakeven next year.

Has sufficient cash runway for more than 3 years based on current free cash flows.

Trading below our estimate of fair value by more than 20%.

Threat

Paying a dividend but company is unprofitable.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Gooch & Housego, we've compiled three important factors you should consider:

Financial Health: Does GHH have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk. Future Earnings: How does GHH'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM every day. If you want to find the calculation for other stocks 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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