A Look At The Fair Value Of Spirent Communications plc (LON:SPT)

Key Insights

• The projected fair value for Spirent Communications is UK£1.56 based on 2 Stage Free Cash Flow to Equity

• With UK£1.80 share price, Spirent Communications appears to be trading close to its estimated fair value

• Analyst price target for SPT is US$2.35, which is 51% above our fair value estimate

In this article we are going to estimate the intrinsic value of Spirent Communications plc (LON:SPT) by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

Check out our latest analysis for Spirent Communications

The Method

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

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$82.5m	US$87.4m	US$91.7m	US$89.0m	US$87.5m	US$86.8m	US$86.6m	US$86.7m	US$87.1m	US$87.7m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x4	Est @ -2.93%	Est @ -1.71%	Est @ -0.85%	Est @ -0.25%	Est @ 0.17%	Est @ 0.46%	Est @ 0.67%
Present Value ($, Millions) Discounted @ 8.2%	US$76.2	US$74.7	US$72.5	US$65.0	US$59.1	US$54.1	US$49.9	US$46.2	US$42.9	US$39.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$581m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (1.2%) 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$88m× (1 + 1.2%) ÷ (8.2%– 1.2%) = US$1.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.3b÷ ( 1 + 8.2%)¹⁰= US$574m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$1.2b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.8, 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

The 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 Spirent Communications 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 8.2%, which is based on a levered beta of 1.009. 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 Spirent Communications

Strength

• Currently debt free.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Communications industry.

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

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

• Significant insider buying over the past 3 months.

Threat

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

Next Steps:

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. 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 Spirent Communications, there are three important aspects you should explore:

1. Risks: We feel that you should assess the 1 warning sign for Spirent Communications we've flagged before making an investment in the company.

2. Future Earnings: How does SPT'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE 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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