A Look At The Fair Value Of Eagle Eye Solutions Group plc (LON:EYE)

Today we will run through one way of estimating the intrinsic value of Eagle Eye Solutions Group plc (LON:EYE) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ 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. 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 Eagle Eye Solutions Group

What's The Estimated Valuation?

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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£3.85m	UK£5.05m	UK£6.65m	UK£7.84m	UK£8.86m	UK£9.69m	UK£10.4m	UK£10.9m	UK£11.3m	UK£11.7m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ 17.97%	Est @ 12.92%	Est @ 9.39%	Est @ 6.92%	Est @ 5.19%	Est @ 3.98%	Est @ 3.13%
Present Value (£, Millions) Discounted @ 6.9%	UK£3.6	UK£4.4	UK£5.4	UK£6.0	UK£6.4	UK£6.5	UK£6.5	UK£6.4	UK£6.2	UK£6.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£58m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 6.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£12m× (1 + 1.2%) ÷ (6.9%– 1.2%) = UK£207m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£207m÷ ( 1 + 6.9%)¹⁰= UK£106m

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£164m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£5.4, the company appears about fair value at a 4.7% 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

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 Eagle Eye Solutions 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 6.9%, which is based on a levered beta of 0.820. 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 Eagle Eye Solutions Group

Strength

• Currently debt free.

Weakness

• 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

• No apparent threats visible for EYE.

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Eagle Eye Solutions Group, we've compiled three additional items you should explore:

1. Risks: For example, we've discovered 2 warning signs for Eagle Eye Solutions Group that you should be aware of before investing here.

2. Future Earnings: How does EYE'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 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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