What is the distance between Image Resources NL (ASX:IMA) and its inherent value? We’ll predict the stock’s future cash flows and discount them to its current value using the most recent financial data to see if it is reasonably valued. We’ll use the Discounted Cash Flow (DCF) model for this. Though it can seem complicated, there isn’t actually much to it.
We would point out that there are many different approaches to evaluate a company, so a DCF is not always the best option. Check out the Simply Wall St. analysis model if you still have a lot of queries concerning this kind of value.
We will employ a two-stage DCF model, which accounts for two phases of growth as implied by its name. Typically, the first stage is characterised by faster development before levelling off and approaching the terminal value, which is reached during the second “steady growth” period. First things first, we need to predict the cash flows for the next ten years. We have extrapolated the prior free cash flow (FCF) from the company’s most recent reported valuation because we do not have access to analyst predictions of free cash flow. During this time, we predict that firms with declining free cash flow will slow down their rate of decline and companies with increasing free cash flow will slow down their pace of growth. Our intention is to ponder.
We must determine the Terminal Value, which takes into consideration all future cash flows after the first stage, after determining the present value of future cash flows in the first ten-year period. For several reasons, a very cautious growth rate that is limited to the GDP growth of a nation is employed. In this instance, we have projected future growth using the 5-year average of the yield on the 10-year government bond (2.1%). We use a cost of equity of 7.4% to discount future cash flows to today’s value, just as we did for the 10-year “growth” period.
The discounted terminal value plus the entire cash flows for the next 10 years equals the total value, which is AU$57 million in this example, or the total equity value. We divide the equity value by the total number of outstanding shares in the last step. At the time of writing, the company’s share price of AU$0.06 seemed to be approximately fair value. However, valuations are not exact tools; they can drift a few degrees and find themselves in a new galaxy, much like a telescope. Remember this, please.
Two assumptions play a major role in the computation above. The cash flows come in second, while the discount rate comes in first. Developing your own estimate of a company’s potential performance is a component of investment, so run the computation and validate your own hypotheses. The DCF does not provide a complete picture of a company’s potential performance since it does not account for an industry’s potential for cyclicality or a company’s future capital requirements. Instead of using the cost of capital, or weighted average cost of capital, or WACC, which takes debt into account, the cost of equity is utilised as the discount rate because Image Resources is one of our possible shareholders. In this computation, 7.4% was utilised.
While a company’s valuation has significant value, it is only one of several aspects that must be evaluated. DCF models are not the gold standard for valuing investments. Ideally, you would apply several scenarios and hypotheses to see how they would affect the worth of the firm. For example, a little adjustment to the terminal value growth rate might have a significant impact on the final outcome. There are three relevant elements related to Image Resources that you should look into further: