Are GR Engineering Services Limited (ASX:GNG) Investors Paying Above The Intrinsic Value?
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of GR Engineering Services Limited (ASX:GNG) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 GR Engineering Services
The method
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 start off with, we need to estimate 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF (A$, Millions) | AU$6.65m | AU$13.5m | AU$16.3m | AU$11.0m | AU$10.8m | AU$10.7m | AU$10.8m | AU$10.8m | AU$11.0m | AU$11.1m |
Growth Rate Estimate Source | Analyst x2 | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Est @ -0.58% | Est @ 0.2% | Est @ 0.74% | Est @ 1.12% | Est @ 1.39% |
Present Value (A$, Millions) Discounted @ 7.9% | AU$6.2 | AU$11.6 | AU$13.0 | AU$8.1 | AU$7.4 | AU$6.8 | AU$6.3 | AU$5.9 | AU$5.5 | AU$5.2 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$76m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate 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 today's value at a cost of equity of 7.9%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU$11m× (1 + 2.0%) ÷ (7.9%– 2.0%) = AU$193m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$193m÷ ( 1 + 7.9%)10= AU$91m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$167m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$1.3, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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. 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 GR Engineering Services 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 7.9%, which is based on a levered beta of 1.121. 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.
Looking Ahead:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 premium to intrinsic value? For GR Engineering Services, there are three additional elements you should assess:
Risks: For instance, we've identified 1 warning sign for GR Engineering Services that you should be aware of.
Future Earnings: How does GNG'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 ASX every day. If you want to find the calculation for other stocks just search here.
This article by Simply Wall St is general in nature. 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.
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