Calculating The Fair Value Of EROAD Limited (NZSE:ERD)

How far off is EROAD Limited (NZSE:ERD) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. 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. 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 EROAD

Is EROAD fairly valued?

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. 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) estimate

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF (NZ$, Millions)

-NZ$3.60m

-NZ$2.50m

-NZ$1.00m

NZ$4.20m

NZ$8.20m

NZ$16.7m

NZ$24.2m

NZ$31.9m

NZ$39.2m

NZ$45.7m

Growth Rate Estimate Source

Analyst x3

Analyst x3

Analyst x3

Analyst x3

Analyst x1

Analyst x1

Est @ 44.64%

Est @ 31.89%

Est @ 22.96%

Est @ 16.72%

Present Value (NZ$, Millions) Discounted @ 7.8%

-NZ$3.3

-NZ$2.2

-NZ$0.8

NZ$3.1

NZ$5.6

NZ$10.6

NZ$14.3

NZ$17.5

NZ$19.9

NZ$21.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$86m

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.8%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = NZ$46m× (1 + 2.1%) ÷ (7.8%– 2.1%) = NZ$826m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$826m÷ ( 1 + 7.8%)10= NZ$390m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$476m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$6.1, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

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Important assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 EROAD 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 7.8%, which is based on a levered beta of 1.197. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess 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?" 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. For EROAD, there are three additional factors you should assess:

  1. Risks: As an example, we've found 3 warning signs for EROAD that you need to consider before investing here.

  2. Future Earnings: How does ERD'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 NZSE every day. If you want to find the calculation for other stocks just search here.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

By Matt Earle

Matthew Earle is the Founder of MiningFeeds. In 2005, Matt founded MiningNerds.com to provide data and information to the mining investment community. This site was merged with Highgrade Review to form MiningFeeds. Matt has a B.Sc. degree with a minor in geology from the University of Toronto.

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