Calculating The Intrinsic Value Of Software Circle plc (LON:SFT)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Software Circle fair value estimate is UK£0.12

• Current share price of UK£0.14 suggests Software Circle is potentially trading close to its fair value

• Software Circle's peers seem to be trading at a lower premium to fair value based onthe industry average of -10%

In this article we are going to estimate the intrinsic value of Software Circle plc (LON:SFT) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Software Circle

Crunching The Numbers

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. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£1.23m	UK£1.64m	UK£2.02m	UK£2.36m	UK£2.65m	UK£2.89m	UK£3.09m	UK£3.25m	UK£3.38m	UK£3.50m
Growth Rate Estimate Source	Est @ 46.34%	Est @ 32.89%	Est @ 23.48%	Est @ 16.89%	Est @ 12.28%	Est @ 9.05%	Est @ 6.79%	Est @ 5.21%	Est @ 4.10%	Est @ 3.33%
Present Value (£, Millions) Discounted @ 7.4%	UK£1.1	UK£1.4	UK£1.6	UK£1.8	UK£1.9	UK£1.9	UK£1.9	UK£1.8	UK£1.8	UK£1.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£17m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.5%) 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 7.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£3.5m× (1 + 1.5%) ÷ (7.4%– 1.5%) = UK£61m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£61m÷ ( 1 + 7.4%)¹⁰= UK£30m

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£47m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.1, the company appears around fair value at the time of writing. 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.

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Software Circle 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 7.4%, which is based on a levered beta of 0.992. 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 Software Circle

Strength

• Cash in surplus of total debt.

Weakness

• Current share price is above our estimate of fair value.

• Shareholders have been diluted in the past year.

Opportunity

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

• Lack of analyst coverage makes it difficult to determine SFT's earnings prospects.

Threat

• Debt is not well covered by operating cash flow.

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. For Software Circle, we've put together three important items you should assess:

1. Risks: For example, we've discovered 2 warning signs for Software Circle (1 is concerning!) that you should be aware of before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SFT's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.