Stock Analysis

A Look At The Intrinsic Value Of Gem Diamonds Limited (LON:GEMD)

LSE:GEMD
Source: Shutterstock

Key Insights

  • Gem Diamonds' estimated fair value is UK£0.30 based on 2 Stage Free Cash Flow to Equity
  • Gem Diamonds' UK£0.26 share price indicates it is trading at similar levels as its fair value estimate
  • When compared to theindustry average discount to fair value of 7.7%, Gem Diamonds' competitors seem to be trading at a lesser discount

Does the March share price for Gem Diamonds Limited (LON:GEMD) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Gem Diamonds

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. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$9.50m US$7.10m US$5.81m US$5.08m US$4.66m US$4.40m US$4.25m US$4.16m US$4.11m US$4.09m
Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ -18.24% Est @ -12.42% Est @ -8.35% Est @ -5.50% Est @ -3.50% Est @ -2.11% Est @ -1.13% Est @ -0.45%
Present Value ($, Millions) Discounted @ 11% US$8.6 US$5.8 US$4.3 US$3.4 US$2.8 US$2.4 US$2.1 US$1.8 US$1.6 US$1.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$34m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$4.1m× (1 + 1.2%) ÷ (11%– 1.2%) = US$43m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$43m÷ ( 1 + 11%)10= US$16m

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$50m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.3, the company appears about fair value at a 11% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
LSE:GEMD Discounted Cash Flow March 17th 2023

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Gem Diamonds 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 11%, which is based on a levered beta of 1.368. 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.

SWOT Analysis for Gem Diamonds

Strength
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
  • Dividend is in the top 25% of dividend payers in the market.
Weakness
  • Earnings declined over the past year.
Opportunity
  • Current share price is below our estimate of fair value.
Threat
  • No apparent threats visible for GEMD.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. For Gem Diamonds, we've put together three relevant items you should further research:

  1. Risks: Take risks, for example - Gem Diamonds has 3 warning signs we think you should be aware of.
  2. Future Earnings: How does GEMD'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 LSE every day. If you want to find the calculation for other stocks just search here.

New: Manage All Your Stock Portfolios in One Place

We've created the ultimate portfolio companion for stock investors, and it's free.

• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks

Try a Demo Portfolio for Free

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.