Key Insights

The projected fair value for ITM Power is UK£0.62 based on Dividend Discount Model Current share price of UK£0.65 suggests ITM Power is potentially trading close to its fair value Our fair value estimate is 51% lower than ITM Power's analyst price target of UK£1.25

In this article we are going to estimate the intrinsic value of ITM Power Plc (LON:ITM) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for ITM Power

The Model

As ITM Power operates in the electrical sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. This often underestimates the value of a stock, but it can still be good as a comparison to competitors. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. For a number of reasons a very conservative growth rate is used that cannot exceed that of a company's Gross Domestic Product (GDP). In this case we used the 5-year average of the 10-year government bond yield (1.4%). The expected dividend per share is then discounted to today's value at a cost of equity of 9.1%. Compared to the current share price of UK£0.6, the company appears around fair value at the time of writing. 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.



Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= UK£0.05 / (9.1% – 1.4%)

= UK£0.6 dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 ITM Power 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 9.1%, which is based on a levered beta of 1.306. 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 ITM Power

Strength

Currently debt free.

Weakness

Current share price is above our estimate of fair value.

Opportunity

Forecast to reduce losses next year.

Has sufficient cash runway for more than 3 years based on current free cash flows.

Threat

Not expected to become profitable over the next 3 years.

Looking Ahead:

Although the valuation of a company is important, 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. 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 ITM Power, there are three fundamental aspects you should consider:

Risks: Consider for instance, the ever-present spectre of investment risk.  We've identified 1 warning sign  with ITM Power , and understanding this should be part of your investment process. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ITM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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.