Gates Industrial Corporation plc Embedded Value Estimate (NYSE: GTES)
Does Gates Industrial Corporation plc (NYSE: GTES) April Price Reflect What It Is Really Worth? Today we will estimate the intrinsic value of the security by taking expected future cash flows and discounting them to their present value. Our analysis will use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
We would like to point out 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.
What is the estimated valuation?
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”. First, 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 last estimate or the last reported value. 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, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | USD 275.9 million | $ 330.0 million | $ 365.0 million | $ 390.9 million | $ 412.8 million | 431.4 million USD | $ 447.7 million | $ 462.3 million | $ 475.6 million | 488.2 million USD |
Source of estimated growth rate | Analyst x2 | Analyst x1 | Analyst x1 | Is 7.1% | Is 5.58% | Is 4.52% | Is 3.78% | Is at 3.26% | Is 2.89% | Is 2.64% |
Present value ($, millions) discounted at 9.3% | US $ 252 | US $ 276 | US $ 280 | US $ 274 | US $ 265 | US $ 253 | US $ 241 | US $ 227 | $ 214 | $ 201 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 2.5 billion USD
Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. 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 9.3%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = $ 488 million × (1 + 2.0%) ÷ (9.3% – 2.0%) = $ 6.9 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $ 6.9 billion ÷ (1 + 9.3%)^{ten}= 2.8 billion USD
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 5.3 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 17.2, the company appears to have fair value at a discount of 5.8% 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.
NYSE: GTES Discounted Cash Flow April 19, 2021
Important assumptions
We draw your attention to the fact that the most important data for a discounted cash flow is 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 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 Gates Industrial 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 used 9.3%, which is based on a leveraged beta of 1.383. 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.
Next steps:
While important, the DCF calculation ideally won’t be the only analysis you look at for a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Gates Industrial, we’ve put together three essentials you should consider:
- Risks: You should be aware of the 3 warning signs for Gates Industrial (1 shouldn’t be ignored!) Which we found out before considering an investment in the business.
- Future income: How does GTES’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. If you want to find the calculation for other actions, just search here.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.
Do you have any comments on this article? Concerned about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.