Is Essentra plc (LON:ESNT) Trading At A 48% Discount?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Essentra fair value estimate is UK£3.34

• Essentra's UK£1.73 share price signals that it might be 48% undervalued

• Analyst price target for ESNT is UK£2.61 which is 22% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Essentra plc (LON:ESNT) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Essentra

Is Essentra Fairly Valued?

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. To start off with, we need to estimate 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, 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£28.8m	UK£34.7m	UK£47.0m	UK£54.5m	UK£59.9m	UK£64.4m	UK£68.0m	UK£71.1m	UK£73.6m	UK£75.7m
Growth Rate Estimate Source	Analyst x7	Analyst x7	Analyst x1	Analyst x1	Est @ 9.98%	Est @ 7.44%	Est @ 5.66%	Est @ 4.42%	Est @ 3.55%	Est @ 2.94%
Present Value (£, Millions) Discounted @ 7.7%	UK£26.7	UK£29.9	UK£37.6	UK£40.5	UK£41.3	UK£41.2	UK£40.4	UK£39.2	UK£37.7	UK£36.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£371m

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£76m× (1 + 1.5%) ÷ (7.7%– 1.5%) = UK£1.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£1.2b÷ ( 1 + 7.7%)¹⁰= UK£590m

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£961m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£1.7, the company appears quite good value at a 48% 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

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 Essentra 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 7.7%, which is based on a levered beta of 1.048. 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 Essentra

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

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

Moving On:

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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value? For Essentra, there are three important elements you should further examine:

1. Financial Health: Does ESNT 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.

2. Future Earnings: How does ESNT'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.

3. 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 British stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.