Calculating The Fair Value Of Gem Diamonds Limited (LON:GEMD)

How far off is Gem Diamonds Limited (LON:GEMD) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Gem Diamonds

Step by step through the calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF ($, Millions)

US$15.2m

US$10.0m

US$7.91m

US$6.77m

US$6.11m

US$5.71m

US$5.46m

US$5.31m

US$5.22m

US$5.18m

Growth Rate Estimate Source

Analyst x2

Analyst x1

Est @ -20.92%

Est @ -14.37%

Est @ -9.78%

Est @ -6.57%

Est @ -4.32%

Est @ -2.75%

Est @ -1.65%

Est @ -0.88%

Present Value ($, Millions) Discounted @ 7.1%

US$14.2

US$8.7

US$6.4

US$5.1

US$4.3

US$3.8

US$3.4

US$3.1

US$2.8

US$2.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$54m

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. 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 (0.9%) 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 7.1%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$5.2m× (1 + 0.9%) ÷ (7.1%– 0.9%) = US$85m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$85m÷ ( 1 + 7.1%)10= US$43m

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$97m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£0.6, the company appears around fair value at the time of writing. 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.

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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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 7.1%, which is based on a levered beta of 1.161. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. For Gem Diamonds, we've compiled three further aspects you should assess:

  1. Risks: We feel that you should assess the 3 warning signs for Gem Diamonds (1 makes us a bit uncomfortable!) we've flagged before making an investment in the company.

  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 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 LSE every day. If you want to find the calculation for other stocks just search here.

This article by Simply Wall St is general in nature. 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 (at) simplywallst.com.

By Matt Earle

Matthew Earle is the Founder of MiningFeeds. In 2005, Matt founded MiningNerds.com to provide data and information to the mining investment community. This site was merged with Highgrade Review to form MiningFeeds. Matt has a B.Sc. degree with a minor in geology from the University of Toronto.

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