Key Insights

• Integral Diagnostics' estimated fair value is AU$4.08 based on 2 Stage Free Cash Flow to Equity
• Integral Diagnostics' AU$2.27 share price signals that it might be 44% undervalued
• Our fair value estimate is 29% higher than Integral Diagnostics' analyst price target of AU$3.15

Today we will run through one way of estimating the intrinsic value of Integral Diagnostics Limited (ASX:IDX) by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

Our free stock report includes 3 warning signs investors should be aware of before investing in Integral Diagnostics. Read for free now.

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (A$, Millions)	AU$20.0m	AU$54.8m	AU$59.8m	AU$61.0m	AU$64.0m	AU$66.5m	AU$68.9m	AU$71.2m	AU$73.4m	AU$75.6m
Growth Rate Estimate Source	Analyst x4	Analyst x6	Analyst x6	Analyst x2	Analyst x2	Est @ 3.92%	Est @ 3.56%	Est @ 3.32%	Est @ 3.14%	Est @ 3.02%
Present Value (A$, Millions) Discounted @ 6.5%	AU$18.8	AU$48.3	AU$49.5	AU$47.4	AU$46.7	AU$45.5	AU$44.3	AU$42.9	AU$41.6	AU$40.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$425m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.7%) 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 6.5%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = AU$76m× (1 + 2.7%) ÷ (6.5%– 2.7%) = AU$2.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$2.1b÷ ( 1 + 6.5%)¹⁰= AU$1.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$1.5b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.3, the company appears quite good value at a 44% 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.

The Assumptions

Now 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 Integral Diagnostics 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 6.5%, which is based on a levered beta of 0.874. 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.

View our latest analysis for Integral Diagnostics

SWOT Analysis for Integral Diagnostics

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. 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. What is the reason for the share price sitting below the intrinsic value? For Integral Diagnostics, there are three additional elements you should assess:

1. Risks: Be aware that Integral Diagnostics is showing 3 warning signs in our investment analysis , and 2 of those are a bit concerning...
2. Future Earnings: How does IDX'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 ASX 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.