Today we are going to review one way to estimate the intrinsic value of Gold Town Games AB (publ) (NGM: GTG) by taking the expected future cash flows of the business and discounting them to present value. . We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too hard to follow, as you will see in our example!
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read Simply Wall St analysis model.
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Step by step in the calculation
We are going to use a two-step DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Since no analysts estimate of free cash flow is available to us, we have extrapolated past free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
|Leverage FCF (SEK, millions)||1.21 million kr||1.63 million kr||2.03 million kr||2.37 million kr||2.66 million kr||2.88 million kr||3.06 kr||3.19 million kr||3.29 million kr||3.36 million kr|
|Source of estimated growth rate||Is 48.96%||Is 34.37%||Is 24.16%||Is at 17.01%||Est @ 12.01%||Is 8.5%||Is 6.05%||Is 4.33%||Is 3.13%||Is at 2.29%|
|Present value (SEK, million) discounted at 5.4%||1.2 kr||1.5 kr||1.7 kr||1.9 kr||kr2.0||kr2.1||kr2.1||kr2.1||kr2.1||kr2.0|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 18 million kr
Now we need to calculate the terminal value, which takes into account all future cash flows after that 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 used the 5-year average of the 10-year government bond yield (0.3%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 5.4%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = kr3.4m × (1 + 0.3%) ÷ (5.4% – 0.3%) = kr67m
Present value of terminal value (PVTV)= TV / (1 + r)ten= kr67m ÷ (1 + 5.4%)ten= kr40m
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is 58 million kr. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of 1.6 kr, the company appears on the fair value at a discount of 19% from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Gold Town Games 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 takes debt into account. In this calculation, we have used 5.4%, which is based on a leveraged beta of 1.067. Beta is a measure of the volatility of a stock, relative 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.
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 business. The DCF model is not a perfect inventory valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Gold Town Games, we have put together three relevant things that you need to evaluate:
- Risks: As an example, we found 5 warning signs for the Gold Town Games (2 cannot be ignored!) Which you must consider before investing here.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
- Other Best Analyst Picks: Interested in seeing what analysts think? Take a look at our interactive list of analysts’ top stock picks to find out what they think may have exciting prospects for the future!
PS. Simply Wall St updates its DCF calculation for every Swedish stock every day, so if you want to find the intrinsic value of any other stock just search here.
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