Today we’re going to review one way to estimate the intrinsic value of Activision Blizzard, Inc. (NASDAQ: ATVI) by estimating the company’s future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

The method

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”. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the latest estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

Generally, we assume that a dollar today is worth more 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) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 25 billion

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.8%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 3.9B × (1 + 2.0%) ÷ (6.8% – 2.0%) = US $ 81B

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 81 billion ÷ (1 + 6.8%)^ten= US $ 42 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 67 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 72.8, the company appears to be roughly at fair value with a 16% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

NasdaqGS: ATVI Discounted Cash Flows September 23, 2021

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 full picture of a company’s potential performance. Since we view Activision Blizzard 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 into account debt. In this calculation, we used 6.8%, which is based on a leveraged beta of 1.023. 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 from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.

To move on :

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. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Activision Blizzard, you need to explore three relevant factors:

1. Risks: As an example, we have found 1 warning sign for Activision Blizzard that you need to consider before investing here.
2. Management: Have insiders increased their stocks to take advantage of market sentiment about ATVI’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.

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