dotdigital Group Plc's (LON:DOTD) Intrinsic Value Is Potentially 18% Below Its Share Price

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, dotdigital Group fair value estimate is UK£0.78

• Current share price of UK£0.94 suggests dotdigital Group is potentially 21% overvalued

• Analyst price target for DOTD is UK£1.23, which is 58% above our fair value estimate

How far off is dotdigital Group Plc (LON:DOTD) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for dotdigital Group

Is dotdigital Group Fairly Valued?

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. 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.

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£10.5m	UK£11.6m	UK£13.2m	UK£13.7m	UK£14.1m	UK£14.4m	UK£14.7m	UK£15.0m	UK£15.3m	UK£15.6m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x3	Est @ 3.31%	Est @ 2.81%	Est @ 2.46%	Est @ 2.21%	Est @ 2.04%	Est @ 1.92%	Est @ 1.84%
Present Value (£, Millions) Discounted @ 7.1%	UK£9.8	UK£10.1	UK£10.8	UK£10.4	UK£10.0	UK£9.5	UK£9.1	UK£8.7	UK£8.2	UK£7.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£94m

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 (1.6%) 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 7.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£16m× (1 + 1.6%) ÷ (7.1%– 1.6%) = UK£288m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£288m÷ ( 1 + 7.1%)¹⁰= UK£145m

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£239m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.9, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important 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 dotdigital 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 7.1%, which is based on a levered beta of 1.003. 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 dotdigital Group

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Currently debt free.

Weakness

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

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

• Shareholders have been diluted in the past year.

Opportunity

• Annual revenue is forecast to grow faster than the British market.

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

Threat

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

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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. Can we work out why the company is trading at a premium to intrinsic value? For dotdigital Group, we've compiled three further aspects you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with dotdigital Group , and understanding this should be part of your investment process.

2. Future Earnings: How does DOTD'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.

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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.