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Are Investors Undervaluing CGI Inc. (TSE:GIB.A) By 20%?

Simply Wall St

In this article we are going to estimate the intrinsic value of CGI Inc. (TSE:GIB.A) by estimating the company's future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for CGI

The method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (CA$, Millions) CA$1.47b CA$1.64b CA$1.76b CA$1.85b CA$1.93b CA$1.99b CA$2.05b CA$2.10b CA$2.15b CA$2.19b
Growth Rate Estimate Source Analyst x8 Analyst x8 Analyst x2 Est @ 5.1% Est @ 4.07% Est @ 3.35% Est @ 2.84% Est @ 2.49% Est @ 2.24% Est @ 2.07%
Present Value (CA$, Millions) Discounted @ 8.2% CA$1.4k CA$1.4k CA$1.4k CA$1.4k CA$1.3k CA$1.2k CA$1.2k CA$1.1k CA$1.1k CA$1.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$12b

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 10-year government bond rate (1.7%) 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 8.2%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = CA$2.2b× (1 + 1.7%) ÷ 8.2%– 1.7%) = CA$34b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$34b÷ ( 1 + 8.2%)10= CA$16b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$28b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$87.2, the company appears a touch undervalued at a 20% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

TSX:GIB.A Intrinsic value May 23rd 2020

The 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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 CGI 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 8.2%, which is based on a levered beta of 1.080. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching 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?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For CGI, We've compiled three additional aspects you should further examine:

  1. Risks: Take risks, for example - CGI has 1 warning sign we think you should be aware of.
  2. Future Earnings: How does GIB.A'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX 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. 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. Thank you for reading.