Calculating The Fair Value Of ESCO Technologies Inc. (NYSE:ESE)

Key Insights

• The projected fair value for ESCO Technologies is US$169 based on 2 Stage Free Cash Flow to Equity
• ESCO Technologies' US$195 share price indicates it is trading at similar levels as its fair value estimate

Today we will run through one way of estimating the intrinsic value of ESCO Technologies Inc. (NYSE:ESE) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

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The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF ($, Millions)	US$209.7m	US$222.8m	US$233.7m	US$244.0m	US$253.9m	US$263.5m	US$273.2m	US$282.8m	US$292.6m	US$302.5m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 4.88%	Est @ 4.40%	Est @ 4.05%	Est @ 3.82%	Est @ 3.65%	Est @ 3.53%	Est @ 3.45%	Est @ 3.39%
Present Value ($, Millions) Discounted @ 8.4%	US$193	US$190	US$184	US$177	US$170	US$163	US$155	US$149	US$142	US$135

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.7b

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 3.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = US$303m× (1 + 3.3%) ÷ (8.4%– 3.3%) = US$6.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$6.1b÷ ( 1 + 8.4%)¹⁰= US$2.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$4.4b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$195, the company appears around fair value 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.

Important Assumptions

We would point out that 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 ESCO Technologies 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 8.4%, which is based on a levered beta of 1.109. 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.

Check out our latest analysis for ESCO Technologies

SWOT Analysis for ESCO Technologies

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For ESCO Technologies, we've put together three fundamental elements you should further examine:

1. Risks: As an example, we've found 1 warning sign for ESCO Technologies that you need to consider before investing here.
2. Future Earnings: How does ESE'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 NYSE 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.