Key Insights

The projected fair value for Integral Diagnostics is AU$3.64 based on 2 Stage Free Cash Flow to Equity

Current share price of AU$3.22 suggests Integral Diagnostics is potentially trading close to its fair value

Analyst price target for IDX is AU$3.23 which is 11% below our fair value estimate

In this article we are going to estimate the intrinsic value of Integral Diagnostics Limited (ASX:IDX) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

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.

View our latest analysis for Integral Diagnostics

Step By Step Through The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

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10-year free cash flow (FCF) forecast

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 Levered FCF (A$, Millions) AU$33.3m AU$40.6m AU$33.5m AU$39.2m AU$40.2m AU$41.2m AU$42.2m AU$43.1m AU$44.0m AU$45.0m Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x1 Analyst x1 Est @ 2.63% Est @ 2.44% Est @ 2.31% Est @ 2.22% Est @ 2.16% Est @ 2.11% Present Value (A$, Millions) Discounted @ 6.4% AU$31.3 AU$35.8 AU$27.8 AU$30.6 AU$29.5 AU$28.4 AU$27.3 AU$26.2 AU$25.2 AU$24.2

("Est" = FCF growth rate estimated by Simply Wall St)

Present Value of 10-year Cash Flow (PVCF) = AU$286m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF 2033 × (1 + g) ÷ (r – g) = AU$45m× (1 + 2.0%) ÷ (6.4%– 2.0%) = AU$1.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$1.0b÷ ( 1 + 6.4%)10= AU$561m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$847m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$3.2, the company appears about fair value at a 11% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

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The Assumptions

Now 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 Integral Diagnostics 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 6.4%, which is based on a levered beta of 0.879. 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 Integral Diagnostics

Strength

Debt is well covered by cash flow.

Dividends are covered by earnings and cash flows.

Weakness

Earnings declined over the past year.

Interest payments on debt are not well covered.

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

Opportunity

Annual earnings are forecast to grow faster than the Australian market.

Current share price is below our estimate of fair value.

Threat

Revenue is forecast to grow slower than 20% per year.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Integral Diagnostics, we've compiled three pertinent elements you should assess:

Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Integral Diagnostics , and understanding this should be part of your investment process. Future Earnings: How does IDX'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 Australian 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.