An Intrinsic Calculation For Computer Modelling Group Ltd. (TSE:CMG) Suggests It's 35% Undervalued

Key Insights

• The projected fair value for Computer Modelling Group is CA$20.29 based on 2 Stage Free Cash Flow to Equity

• Computer Modelling Group is estimated to be 35% undervalued based on current share price of CA$13.19

• Analyst price target for CMG is CA$13.14 which is 35% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Computer Modelling Group Ltd. (TSE:CMG) 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. 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Computer Modelling Group

The Model

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 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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CA$, Millions)	CA$35.6m	CA$43.9m	CA$53.0m	CA$63.0m	CA$73.0m	CA$80.4m	CA$86.6m	CA$91.8m	CA$96.2m	CA$100.0m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x1	Analyst x1	Analyst x1	Est @ 10.10%	Est @ 7.69%	Est @ 6.01%	Est @ 4.83%	Est @ 4.01%
Present Value (CA$, Millions) Discounted @ 6.7%	CA$33.4	CA$38.6	CA$43.7	CA$48.7	CA$52.8	CA$54.5	CA$55.1	CA$54.7	CA$53.8	CA$52.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$488m

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 (2.1%) 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 6.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CA$100m× (1 + 2.1%) ÷ (6.7%– 2.1%) = CA$2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$2.2b÷ ( 1 + 6.7%)¹⁰= CA$1.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$1.7b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$13.2, the company appears quite undervalued at a 35% 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

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. 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 Computer Modelling Group 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 6.7%, which is based on a levered beta of 0.999. 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 Computer Modelling Group

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

• Dividends are covered by earnings and cash flows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Software market.

Opportunity

• Annual revenue is forecast to grow faster than the Canadian market.

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

Threat

• Annual earnings are forecast to grow slower than the Canadian market.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Computer Modelling Group, we've compiled three essential elements you should look at:

1. Risks: Be aware that Computer Modelling Group is showing 1 warning sign in our investment analysis , you should know about...

2. Future Earnings: How does CMG'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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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.

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