Is There An Opportunity With ECO Animal Health Group plc's (LON:EAH) 42% Undervaluation?

Key Insights

• ECO Animal Health Group's estimated fair value is UK£1.77 based on 2 Stage Free Cash Flow to Equity

• ECO Animal Health Group's UK£1.03 share price signals that it might be 42% undervalued

• Analyst price target for EAH is UK£1.85, which is 4.8% above our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ECO Animal Health Group plc (LON:EAH) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 ECO Animal Health Group

Crunching The Numbers

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£3.26m	UK£3.78m	UK£4.49m	UK£5.60m	UK£7.77m	UK£7.00m	UK£6.57m	UK£6.31m	UK£6.17m	UK£6.11m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Est @ -6.21%	Est @ -3.85%	Est @ -2.20%	Est @ -1.05%
Present Value (£, Millions) Discounted @ 6.0%	UK£3.1	UK£3.4	UK£3.8	UK£4.4	UK£5.8	UK£4.9	UK£4.4	UK£4.0	UK£3.6	UK£3.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£41m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 6.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£6.1m× (1 + 1.6%) ÷ (6.0%– 1.6%) = UK£142m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£142m÷ ( 1 + 6.0%)¹⁰= UK£79m

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£120m. 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£1.0, the company appears quite good value at a 42% discount to where the stock price trades currently. 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 ECO Animal Health Group 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 6.0%, which is based on a levered beta of 0.800. 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:

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. 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. Can we work out why the company is trading at a discount to intrinsic value? For ECO Animal Health Group, we've put together three further factors you should consider:

1. Risks: For example, we've discovered 1 warning sign for ECO Animal Health Group that you should be aware of before investing here.

2. Future Earnings: How does EAH'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 AIM every day. If you want to find the calculation for other stocks 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.