An Intrinsic Calculation For Gear4music (Holdings) plc (LON:G4M) Suggests It's 40% Undervalued

Key Insights

• The projected fair value for Gear4music (Holdings) is UK£2.27 based on 2 Stage Free Cash Flow to Equity

• Gear4music (Holdings) is estimated to be 40% undervalued based on current share price of UK£1.37

Does the April share price for Gear4music (Holdings) plc (LON:G4M) 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. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

See our latest analysis for Gear4music (Holdings)

The Calculation

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£4.74m	UK£5.12m	UK£4.89m	UK£4.76m	UK£4.69m	UK£4.67m	UK£4.67m	UK£4.70m	UK£4.74m	UK£4.80m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ -4.58%	Est @ -2.71%	Est @ -1.41%	Est @ -0.49%	Est @ 0.15%	Est @ 0.59%	Est @ 0.91%	Est @ 1.13%
Present Value (£, Millions) Discounted @ 11%	UK£4.3	UK£4.2	UK£3.6	UK£3.2	UK£2.8	UK£2.5	UK£2.3	UK£2.1	UK£1.9	UK£1.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£29m

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 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£4.8m× (1 + 1.6%) ÷ (11%– 1.6%) = UK£53m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£53m÷ ( 1 + 11%)¹⁰= UK£19m

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 UK£48m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.4, the company appears quite undervalued at a 40% 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

The 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. 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 Gear4music (Holdings) 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 1.668. 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 Gear4music (Holdings)

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

Opportunity

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Trading below our estimate of fair value by more than 20%.

Threat

• No apparent threats visible for G4M.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Gear4music (Holdings), there are three fundamental items you should look at:

1. Risks: Be aware that Gear4music (Holdings) is showing 3 warning signs in our investment analysis , and 2 of those don't sit too well with us...

2. Future Earnings: How does G4M'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 High Quality Alternatives: Do you like a good all-rounder? 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 valuation for every stock on the AIM 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.