Step by step through the calculation
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF ($, Millions) | $-93.83 | $-115.45 | $97.00 | $138.00 | $152.00 |
| Source | Analyst x3 | Analyst x4 | Analyst x2 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 17.58% | $-79.80 | $-83.51 | $59.67 | $72.20 | $67.63 |
Present Value of 5-year Cash Flow (PVCF)= $36
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.1%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 17.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $152 × (1 + 2.1%) ÷ (17.6% – 2.1%) = $1,005
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $1,005 / ( 1 + 17.6%)5 = $447
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CA$483. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of CA$5.77, which, compared to the current share price of CA$4.9, we find that Teranga Gold is about right, perhaps slightly undervalued at a 15.12% discount to what it is available for right now.
Important assumptions
Now 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Teranga Gold as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 17.6%, which is based on a levered beta of 1.963. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For TGZ, there are three fundamental aspects you should further research:
- Financial Health: Does TGZ 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.
- Future Earnings: How does TGZ’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of TGZ? 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 for every stock on the TSX every 6 hours. If you want to find the calculation for other stocks just search here.