Stock Analysis

Calculating The Fair Value Of CGI Inc. (TSE:GIB.A)

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TSX:GIB.A
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Does the November share price for CGI Inc. (TSE:GIB.A) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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

Crunching the numbers

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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 (CA$, Millions) CA$1.66b CA$1.82b CA$1.93b CA$2.02b CA$2.10b CA$2.17b CA$2.23b CA$2.29b CA$2.34b CA$2.38b
Growth Rate Estimate Source Analyst x7 Analyst x6 Est @ 6.25% Est @ 4.88% Est @ 3.91% Est @ 3.24% Est @ 2.76% Est @ 2.43% Est @ 2.2% Est @ 2.04%
Present Value (CA$, Millions) Discounted @ 8.6% CA$1.5k CA$1.5k CA$1.5k CA$1.5k CA$1.4k CA$1.3k CA$1.3k CA$1.2k CA$1.1k CA$1.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$13b

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 a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (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 8.6%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$2.4b× (1 + 1.7%) ÷ (8.6%– 1.7%) = CA$35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$35b÷ ( 1 + 8.6%)10= CA$15b

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$29b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$93.5, the company appears about fair value at a 16% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
TSX:GIB.A Discounted Cash Flow November 24th 2020

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 8.6%, which is based on a levered beta of 1.153. 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:

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. 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. For CGI, we've compiled three pertinent elements you should look at:

  1. Risks: Every company has them, and we've spotted 2 warning signs for CGI you should know about.
  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. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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About TSX:GIB.A

CGI

CGI Inc., together with its subsidiaries, provides information technology (IT) and business process services in Canada; Western, Southern, Central, and Eastern Europe; Australia; Scandinavia; Finland, Poland, and Baltics; the United States; the United Kingdom; and the Asia Pacific.

Solid track record with excellent balance sheet.