Evolution Gaming has just recently released its numbers for the final quarter of 2020, and in the end of the year report you'll find on their website you will now find the following table.

As you can see from the figures above, you can quickly get an idea that Evoltion Gaming is a pretty profitable company with both a high return on capital as well as growing earnings.

To us it seems to be a very good company to be an owner of, but how expensive is it to buy shares from the current owners at market price now? The stock price is getting close to 970 SEK at the time of writing.

The price of the stock has had the following development over the last three years.

How much earnings do you get per share? 

The last quarter's earnings report shows a profit per share for the year of €1.51, or about 15 SEK per share.

That means that the company is now priced with a P/E of about 970/15=65. That seems pretty high.

You can see the business figures below.

How much do you pay for the equity of the company?

The company has so far retained and holds about €12.8 per share in equity, or about 130 SEK at the end of Q4-2020. That gives you a P/B ratio of about 970/130=7.5.

A particular change in equity from Q3-2020 to Q4-2020 is a result of the recent aquisition of NetEnt, which Evolution bought by issuing shares.

What do I get if I buy shares at the current price?

The profitability figures look quite strong, but are the future outlooks good enough to justify the current market price?

When you buy a share on the stock market today, it is a former shareholder who gives away his share to you in return of a cash settlement.

So what do I get by buying him out?

Let's assume the following figures:

Price per share: about 970 SEK

Earnings per share: 15 SEK (Q4-2020)

Equity per share: 130 SEK (Q4-2020)

Investment: 1,000,000 SEK

Since P/B is about 7.5 one way of seeing it is that your 1,000,000 SEK investment at a price of 970 SEK per share today gives you only a share of the equity of about 133,000 SEK.

1,000,000 / 7,5 = 133,000. We would get about 1.031 shares in the company.

Let's assume we are interested in estimating what the company's earning power on the tangible business equity capital is. That is, we want to know how much the capital of the owner will generate. We can estimate a figure by looking at the so-called tangible equity capital. We can find this number by going to the balance sheet, and subtracting the goodwill from the equity of the company.

Note that after the buy-out of NetEnt was consolidated into the accounts of Evolution in Q4, the group has now gotten an additional ca 1.8 MEUR in goodwill on its balance sheet.

We can see from the balance sheet that tangible equity capital is about 900 MEUR at the end of 2020 (2,726,171 - 1,834,333 = 891,838, numbers in euro thousands). 

How will my share of the equity in the company develop over time?

Let's try to set up a model that makes an assumption about the profitability ratio of the tangible equity capital, and what this figure will mean for the owners over time.

Let's also assume that Evolution will earn about €450.000 in 2021, and that the profitability of the net tangible equity capital is about 70% in the beginning. In our view it has had about this ratio the last five years.

To estimate the further development with a estimated profitability figure, we can set up a model in a spreadsheet. We can for example assume that the return on net tangible equity capital will stay around 70% in the start, but that it will decrease somewhat over the years. And let us assume that the company pays out about half of its earnings in dividends the next 7 years. That's what the management say's it aims to do in its annual reports. Then we might get a table that looks something like this:

The model shows how much capital you as an investor really owns in the company once you have invested a million Swedish Krones. And it shows how much you will earn on that capital given that it continues to turn out to be as profitable in the future as it has been in the past. What we see in the model is that your share of the business equity will start to grow over time, and that you also will get a growing dividend as well.

The idea of setting up this overview is to show you what is your relative equty capital in the business when you as an investor have paid a premium to book value for the shares. And the overview shows you that your share of the capital grows over time, since the company is retaining half of its earnings. The rest of the earnings are paid out in dividends which will leave the company's account and go to the owners' pockets.

One of the key points we'd like you to learn is the following:

A profitable company that continues to increase it's equity captial will get more and more capital to earn more money with. If the management can continue to maintain the high ratio of profitability on its capital, the earnings will grow over time, because they have more and more capital to work with. Very good companies can manage to sustain its profitability ratio over time, and therefore, the more equity capital, the more it will earn.

You can compare this with having a high earning savings account. The more you deposit into the account, the more you get in earnings, as long as the interest rate of the account is high. The interest in the savings account can be compares with the company's return on equity.

In the model we assume that we pay a good premium to book value (a ratio of about 7.5) and we are left with only abouot 134,000 SEK in the business at the outset. If the company continues to earn well on its equity, we can see the development in the model that it will earn back much of the owner's capital over the next 8 years.

Which return can I expect to get if this example turns out to be correct?

As you see in the model estimates the company could be able to return a lot of capital back to its owners. It does so by building equity in the business as well as paying dividends. We see that we might get the whole value paid back in about 8 years (about 1,000,000 SEK earned back within 2028). By then our annual earnings could have risen to about 190,000 SEK. Such a yearly profit could be worth at least a P/E of 20, if the company has outlooks of growing about 10% per year thereafter. That would give you a valuation of about 3,800,000 SEK for your share of the profits and investment of of 1,000,000 SEK. And it would have given you a stock market price of about 4x the current price, or about 3700 SEK per share. In addition you would have gotten dividends as well.

If the stock market price would climb from 970 to 3700 over 8 years, you'd get an annual return of about 18%. In addition we estimate you'd get total dividends amounting to about 44% of your investment accumulated.

A hypothetical development of the stock price of 970 SEK to 3700 SEK over 8 years would give the following annual return (you can calculate it by yourlsef by using a CAGR-calculator online, for example at https://cagrcalculator.net/).

If you assume that the dividends you extract over the next 8 years will accumulate to about 44% of your investment in total, you'd get the following annual rate of return in addition:

If you add the price return and dividends over the next 8 years, you'd get a total compounded annual growth rate of about 23%. 

You may ask why don't we get a return closer to 70% as we started out with for the return of the net tangible equty capital. That is because we are paying a substantial premium on book value to aquire the shares, as well as a high multiple on its earnings.

When you have done your own estimations, its up to you to assess whether you think you'll get a high enough return to justify the current share price.

The idea of this article is to let the reader get ideas about what it means that a company has a high return on its tangible equity capital, and what it means for the expected relative return if you pay a high price for the stock. 

This article shall not be viewed as investment advice. It is only our estimates that we show with the intention of giving you an example which can be used to education purposes.

If you think about share ownership like you do above, you will see that the longer you own shares in a very profitable company, the quicker you'll get your invested capital back. Good stocks get less risky the longer you own them, claims Warren Buffett.

You can also see that our returns in a profitable company that grows will also increase the company's earning power in relation to the invested amount as more time pass.

The estimates we use is only a case study and our own estimates, based on a few simple assumptions. We are only illustrating a method of estimating future profitability, and it's up to you to determine which numbers you will use.

A warning about buying expensive stocks

If a company's growth starts to decline, the market could start to trade the stock with a lower multiple than before. We had such a case in the case of NetEnt. After the growth stopped a few years ago the stock price fell dramatically. On the other hand this time period gave us a huge opportunity to aquire shares, since the stock price dropped from above 100 SEK to only 15 SEK after the growth stopped. The company was still earning money, but there were other factors, such as lower growth, that made the market price it quite cheap in early 2020.

We haven't paid much emphasis on the valuation of cash flows in the example above, and we have only made a simple valuation of an estimated future profit. But we'll write more about valuation in the following articles.

Now we encourage you to sit down and read the annual report of 2020 once Evolution releases it shortly. See if you can determine what the qualitative factors are. The numbers are only one part of the picture, and there is much more that is important to figure out about a company in order know if is indeed a good company to own and a good investment!