Today we will take a simple overview of a valuation method used to estimate the attractiveness of VIP Entertainment Technologies Inc. (CVE:VIP) as an investment opportunity by taking the company’s expected future cash flows and discounting them to present value. . Our analysis will employ the discounted cash flow (DCF) model. Before you think you won’t be able to understand it, read on! In reality, it is much less complex than you imagine.
However, remember that there are many ways to estimate the value of a company, and a DCF is only one method. For those who are keen learners of stock analysis, the Simply Wall St analysis model here may be something of interest to you.
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We are using the two-stage growth model, which simply means that we take into account two stages of growth for the company. In the initial period, the company may have a higher growth rate and the second stage is generally assumed to have a stable growth rate. To start with, we need to estimate the next ten years of cash flows. Since we do not have analyst estimates on free cash flow, we have extrapolated the previous free cash flow (FCF) from the company’s last reported value. We assume that companies with decreasing free cash flow will see their rate of contraction slow, 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 more in early years than in later years.
In general, we assume that a dollar today is more valuable than a dollar in the future, so the sum of these future cash flows is discounted to today’s value:
10-Year Free Cash Flow (FCF) Estimate
|Leveraged FCF (millions of Canadian dollars)||128.3 thousand Canadian dollars||139.5 thousand Canadian dollars||148.7 thousand Canadian dollars||156.3 thousand Canadian dollars||162.7 thousand Canadian dollars||168.1 thousand Canadian dollars||172.8 thousand Canadian dollars||177.1 thousand Canadian dollars||CA$181.0k||184.7 thousand Canadian dollars|
|Growth rate estimation source||@ 11.78%||est @ 8.74%||@ 6.6%||@ 5.11%||est @ 4.07%||est @ 3.34%||est @ 2.82%||est @ 2.47%||est @ 2.22%||est @ 2.04%|
|Present value (millions of Canadian dollars) discounted at 5.8%||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars||0.1 Canadian dollars|
(“Est” = FHR growth rate estimated by Simply Wall St)
10-year Present Value of Cash Flow (PVCF) = 1 million Canadian dollars
Now we need to calculate the terminal value, which represents all future cash flows after this ten-year period. For various 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 (1.6%) to estimate future growth. As with the 10-year ‘growth’ period, we discount future cash flows to today’s value, using a 5.8% cost of capital.
Terminal value (TV)= FHR2032 × (1 + g) ÷ (r – g) = CA$185k × (1 + 1.6%) ÷ (5.8%– 1.6%) = CA$4.5m
Present Value of Terminal Value (PVTV)= television / (1 + r)10= 4.5 million Canadian dollars ÷ ( 1 + 5.8 %)10= 2.5 million Canadian dollars
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is 3.5 million Canadian dollars. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Relative to the current share price of CA$0.05, the company appears to be reasonably valued at the time of writing. The assumptions in any calculation have a huge impact on the valuation, so it’s best to view this as a rough estimate, not accurate down to the penny.
Now the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is building your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not consider the potential cyclicality of an industry or a company’s future capital requirements, so it does not provide a complete picture of a company’s potential performance. Since we consider VIP Entertainment Technologies as potential shareholders, the cost of capital is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which represents debt. In this calculation we have used 5.8%, which is based on a leveraged beta of 0.991. Beta is a measure of the volatility of a stock, compared to the market as a whole. We derive our beta from the industry average beta of global peers, with a cap imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
Looking to the future:
Although a company’s valuation is important, ideally it won’t be the only piece of analysis you look at for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of capital or risk-free rate can significantly affect the valuation. For VIP Entertainment Technologies, we’ve put together three other things you need to consider:
- risks: Please note that VIP Entertainment Technologies is displaying 6 warning signs in our investment analysis and 5 of them are potentially serious…
- Other Solid Businesses: 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 strong business fundamentals to see if there are any other companies you may not have considered?
- Other environmentally friendly companies: Are you concerned about the environment and do you think consumers will buy more and more green products? Explore our interactive list of companies thinking about a greener future to discover some actions you may not have thought of.
P.S. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock, just look here.
Do you have comments about this article? Concerned about the content? Get in touch with us directly. Alternatively, email the editorial team (at) Simplywallst.com.
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 as financial advice. It is not a recommendation to buy or sell any stock, and it does not take into account your goals or financial situation. Our goal is to provide you with long-term focused analysis driven by fundamental data. Please note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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