Are Computer Modelling Group Ltd. (TSE:CMG) Investors Paying Above The Intrinsic Value?

Does the May share price for Computer Modelling Group Ltd. (TSE:CMG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Computer Modelling Group

The calculation

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. 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, 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) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CA$, Millions)	CA$30.4m	CA$22.2m	CA$25.2m	CA$25.7m	CA$26.2m	CA$26.7m	CA$27.2m	CA$27.6m	CA$28.1m	CA$28.5m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ 2.19%	Est @ 1.99%	Est @ 1.85%	Est @ 1.76%	Est @ 1.69%	Est @ 1.64%	Est @ 1.61%
Present Value (CA$, Millions) Discounted @ 9.3%	CA$27.8	CA$18.6	CA$19.3	CA$18.0	CA$16.8	CA$15.7	CA$14.6	CA$13.6	CA$12.6	CA$11.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$168m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 9.3%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CA$29m× (1 + 1.5%) ÷ (9.3%– 1.5%) = CA$373m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$373m÷ ( 1 + 9.3%)¹⁰= CA$153m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$321m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$5.3, the company appears potentially overvalued at the time of writing. 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.

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. 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 Computer Modelling Group 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 9.3%, which is based on a levered beta of 1.646. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a premium to intrinsic value? For Computer Modelling Group, there are three relevant items you should explore:

1. Risks: As an example, we've found 4 warning signs for Computer Modelling Group (1 doesn't sit too well with us!) that you need to consider before investing here.
2. Future Earnings: How does CMG'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.
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