Is There An Opportunity With Gates Industrial Corporation plc's (NYSE:GTES) 46% Undervaluation?

By
Simply Wall St
Published
March 19, 2022
NYSE:GTES
Source: Shutterstock

Does the March share price for Gates Industrial Corporation plc (NYSE:GTES) 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. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Gates Industrial

The method

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, 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$339.7m US$410.1m US$454.7m US$487.4m US$514.8m US$538.0m US$558.1m US$575.9m US$592.1m US$607.1m
Growth Rate Estimate Source Analyst x3 Analyst x5 Analyst x3 Est @ 7.2% Est @ 5.62% Est @ 4.51% Est @ 3.73% Est @ 3.19% Est @ 2.81% Est @ 2.54%
Present Value ($, Millions) Discounted @ 7.5% US$316 US$355 US$366 US$365 US$359 US$349 US$337 US$323 US$309 US$295

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$3.4b

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 (1.9%) 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 7.5%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$607m× (1 + 1.9%) ÷ (7.5%– 1.9%) = US$11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$11b÷ ( 1 + 7.5%)10= US$5.4b

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$8.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$16.2, the company appears quite good value at a 46% 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
NYSE:GTES Discounted Cash Flow March 19th 2022

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. 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 Gates Industrial 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 7.5%, which is based on a levered beta of 1.313. 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. Can we work out why the company is trading at a discount to intrinsic value? For Gates Industrial, there are three pertinent elements you should consider:

  1. Risks: Be aware that Gates Industrial is showing 1 warning sign in our investment analysis , you should know about...
  2. Future Earnings: How does GTES'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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