Velocity Composites plc (LON:VEL) Shares Could Be 34% Above Their Intrinsic Value Estimate

editorial-team@simplywallst.com (Simply Wall St)

Sat, Jan 25, 2025, 2:03 AM 6 min read

In this article we are going to estimate the intrinsic value of Velocity Composites plc (LON:VEL) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.

See our latest analysis for Velocity Composites

The Method

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. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (£, Millions)	UK£500.0k	UK£519.5k	UK£536.9k	UK£553.0k	UK£568.0k	UK£582.4k	UK£596.5k	UK£610.3k	UK£624.1k	UK£637.9k
Growth Rate Estimate Source	Analyst x1	Est @ 3.90%	Est @ 3.36%	Est @ 2.99%	Est @ 2.72%	Est @ 2.54%	Est @ 2.41%	Est @ 2.32%	Est @ 2.26%	Est @ 2.21%
Present Value (£, Millions) Discounted @ 6.7%	UK£0.5	UK£0.5	UK£0.4	UK£0.4	UK£0.4	UK£0.4	UK£0.4	UK£0.4	UK£0.3	UK£0.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.0m

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 6.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = UK£638k× (1 + 2.1%) ÷ (6.7%– 2.1%) = UK£14m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£14m÷ ( 1 + 6.7%)¹⁰= UK£7.4m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£11m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.3, the company appears potentially overvalued at the time of writing. 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 — AIM:VEL Discounted Cash Flow January 25th 2025

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 Velocity Composites 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 6.7%, which is based on a levered beta of 0.950. 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 Velocity Composites

Strength

Debt is well covered by earnings.

Weakness

Expensive based on P/S ratio and estimated fair value.

Opportunity

Forecast to reduce losses next year.

Threat

Debt is not well covered by operating cash flow.

Has less than 3 years of cash runway based on current free cash flow.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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. 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 premium to intrinsic value? For Velocity Composites, we've compiled three fundamental aspects you should assess:

Risks: Every company has them, and we've spotted 4 warning signs for Velocity Composites you should know about.
Future Earnings: How does VEL'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.
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.