Are Investors Undervaluing CGG (EPA:CGG) By 22%?

Today we will run through one way of estimating the intrinsic value of CGG (EPA:CGG) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for CGG

Is CGG fairly valued?

We're 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 a stable growth rate. To start off with, we need to estimate 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF ($, Millions)	-US$62.8m	US$149.6m	US$265.6m	US$168.2m	US$119.7m	US$95.6m	US$82.3m	US$74.3m	US$69.3m	US$66.1m
Growth Rate Estimate Source	Analyst x1	Analyst x4	Analyst x2	Analyst x1	Est @ -28.85%	Est @ -20.1%	Est @ -13.98%	Est @ -9.7%	Est @ -6.7%	Est @ -4.6%
Present Value ($, Millions) Discounted @ 9.8%	-US$57.2	US$124	US$201	US$116	US$75.1	US$54.7	US$42.9	US$35.3	US$30.0	US$26.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$647m

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 0.3%. We discount the terminal cash flows to today's value at a cost of equity of 9.8%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US$66m× (1 + 0.3%) ÷ (9.8%– 0.3%) = US$701m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$701m÷ ( 1 + 9.8%)¹⁰= US$276m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$923m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of €1.0, the company appears a touch undervalued at a 22% 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.

The assumptions

Now 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 inputs, I recommend redoing the calculations yourself and playing with them. 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 CGG 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 9.8%, which is based on a levered beta of 2.000. 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 is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For CGG, there are three additional items you should further examine:

1. Financial Health: Does CGG 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.
2. Future Earnings: How does CGG'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 ENXTPA 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.