Calculating The Intrinsic Value Of Solid State plc (LON:SOLI)

Key Insights

• The projected fair value for Solid State is UK£12.28 based on 2 Stage Free Cash Flow to Equity

• Solid State's UK£11.30 share price indicates it is trading at similar levels as its fair value estimate

• Our fair value estimate is 20% lower than Solid State's analyst price target of UK£15.43

Does the May share price for Solid State plc (LON:SOLI) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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 Solid State

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. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£2.90m	UK£9.50m	UK£10.5m	UK£11.4m	UK£12.1m	UK£12.6m	UK£13.0m	UK£13.4m	UK£13.7m	UK£14.0m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 10.91%	Est @ 7.98%	Est @ 5.93%	Est @ 4.50%	Est @ 3.49%	Est @ 2.79%	Est @ 2.30%	Est @ 1.95%
Present Value (£, Millions) Discounted @ 9.3%	UK£2.7	UK£8.0	UK£8.1	UK£8.0	UK£7.7	UK£7.4	UK£7.0	UK£6.6	UK£6.2	UK£5.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£67m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 9.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£14m× (1 + 1.2%) ÷ (9.3%– 1.2%) = UK£174m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£174m÷ ( 1 + 9.3%)¹⁰= UK£72m

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£139m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£11.3, the company appears about fair value at a 8.0% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Solid State 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 9.3%, which is based on a levered beta of 1.165. 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 Solid State

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings.

Weakness

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

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the British market.

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

Threat

• Debt is not well covered by operating cash flow.

• Paying a dividend but company has no free cash flows.

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

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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 Solid State, we've compiled three further elements you should look at:

1. Risks: We feel that you should assess the 3 warning signs for Solid State we've flagged before making an investment in the company.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SOLI'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.

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