Is there an opportunity with the 46% undervaluation of Gates Industrial Corporation plc (NYSE: GTES)?

Does the March price of Gates Industrial Corporation plc (NYSE: GTES) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by estimating the future cash flows of the company and discounting them to their present value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are actually quite simple.

We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

Check out our latest analysis for Gates Industrial

The method

We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $3.4 billion

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.5%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = $607 million × (1 + 1.9%) ÷ (7.5%–1.9%) = $11 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= $11 billion ÷ (1 + 7.5%)^ten= $5.4 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $8.8 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of $16.2, the company appears to be good value at a 46% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

We emphasize 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 entries, I recommend you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Gates Industrial 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 factors in debt. In this calculation, we used 7.5%, which is based on a leveraged beta of 1.313. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of 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, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Gates Industrial, there are three relevant elements you need to consider:

1. Risks: Know that Gates Industrial shows 1 warning sign in our investment analysis you should know…
2. Future earnings: How does GTES’ growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other strong companies: 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 trading fundamentals to see if there are any other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.