Electronic Arts Inc. (NASDAQ:EA) Shares Could Be 32% Below Their Intrinsic Value Estimate

Key Insights

• The projected fair value for Electronic Arts is US$206 based on 2 Stage Free Cash Flow to Equity

• Electronic Arts' US$140 share price signals that it might be 32% undervalued

• Our fair value estimate is 36% higher than Electronic Arts' analyst price target of US$152

Today we will run through one way of estimating the intrinsic value of Electronic Arts Inc. (NASDAQ:EA) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Electronic Arts

What's The Estimated Valuation?

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.

Generally we assume that a dollar today is more valuable 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$1.91b	US$2.08b	US$2.35b	US$2.61b	US$2.84b	US$3.02b	US$3.17b	US$3.31b	US$3.43b	US$3.54b
Growth Rate Estimate Source	Analyst x10	Analyst x10	Analyst x8	Analyst x2	Analyst x2	Est @ 6.20%	Est @ 5.03%	Est @ 4.21%	Est @ 3.63%	Est @ 3.23%
Present Value ($, Millions) Discounted @ 7.2%	US$1.8k	US$1.8k	US$1.9k	US$2.0k	US$2.0k	US$2.0k	US$1.9k	US$1.9k	US$1.8k	US$1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$19b

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 (2.3%) 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 7.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$3.5b× (1 + 2.3%) ÷ (7.2%– 2.3%) = US$73b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$73b÷ ( 1 + 7.2%)¹⁰= US$36b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$55b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$140, the company appears quite good value at a 32% 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.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Electronic Arts 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 7.2%, which is based on a levered beta of 1.078. 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 Electronic Arts

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is not viewed as a risk.

Weakness

• Earnings growth over the past year underperformed the Entertainment industry.

• Dividend is low compared to the top 25% of dividend payers in the Entertainment market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings are forecast to grow slower than the American market.

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. Can we work out why the company is trading at a discount to intrinsic value? For Electronic Arts, we've compiled three pertinent factors you should look at:

1. Financial Health: Does EA have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does EA'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.

3. 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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.