The projected fair value for Gear4music (Holdings) is UK￡3.35 based on 2 Stage Free Cash Flow to Equity
Gear4music (Holdings)'s UK￡1.73 share price signals that it might be 48% undervalued
In this article we are going to estimate the intrinsic value of Gear4music (Holdings) plc (LON:G4M) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis 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 begin with, we have to get estimates of 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (￡, Millions)
UK￡5.25m
UK￡7.46m
UK￡6.29m
UK￡5.63m
UK￡5.25m
UK￡5.04m
UK￡4.92m
UK￡4.87m
UK￡4.86m
UK￡4.88m
Growth Rate Estimate Source
Analyst x2
Analyst x2
Est @ -15.72%
Est @ -10.42%
Est @ -6.72%
Est @ -4.12%
Est @ -2.31%
Est @ -1.04%
Est @ -0.15%
Est @ 0.48%
Present Value (￡, Millions) Discounted @ 8.5%
UK￡4.8
UK￡6.3
UK￡4.9
UK￡4.1
UK￡3.5
UK￡3.1
UK￡2.8
UK￡2.5
UK￡2.3
UK￡2.2
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = UK￡37m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this 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 have used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.5%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK￡76m÷ ( 1 + 8.5%)10= UK￡34m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK￡70m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK￡1.7, the company appears quite good value at a 48% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
AIM:G4M Discounted Cash Flow October 3rd 2024
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 Gear4music (Holdings) 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 8.5%, which is based on a levered beta of 1.350. 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 Gear4music (Holdings)
Strength
Debt is well covered by cash flow.
Weakness
Interest payments on debt are not well covered.
Opportunity
Annual revenue is forecast to grow faster than the British market.
Trading below our estimate of fair value by more than 20%.
Threat
No apparent threats visible for G4M.
Moving On:
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to 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 significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Gear4music (Holdings), we've compiled three fundamental items you should further examine:
Future Earnings: How does G4M'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.
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.
