The stock market figures and graphs have been collected from our affiliate partner Börsdata.se, which offers a stock market information platform that gives us tons of data that we need and can make use of for valuing a company. #Advertisement

What you'll get in this article

In this article we will argue that most of the upside that you might get in a short time is gone, but the stock price can still support a decent return if the expected growth rate pans out. We argue that it was possible to calculate that the value was at least twice of the stock market price a year ago, for the investor who wanted a 15% return. We'll share the idea of the DCF valuation method, and we'll show you a few glimpses into the model that we use, and how it might look in different scenarios.

Evolution Gaming continues it's growth

In our last article about Evolution released about one month ago we told the story about how we were lucky to find and hold the stock when it was priced below 200 SEK. And we told you that the price had climbed above 1100 SEK when we released the article. We explained that it was very lucrative to enter the stock back when we did, but at the moment we thought and said:

“Now, as we see the stock price soaring, we are on the lookout of other stocks to put our money in, that have a similar huge upside.”

In other words, we meant that it was a really good stock, but we had our upside when buying around 200 SEK per share. And we also bought some around 600 SEK.

Now the price has climbed even higher and reached 1300 SEK per share. The stock market is enthusiastic about the share, and there are many Diamond Hands out there who believe you should hold no matter what. Others might ask, is the stock overpriced now?

About a year ago we estimated that we would get something in the ballpark of 15% on our investment if we bought the share around 700 SEK. It was then around the time when the stock market crashed due to the outbreak of COVID-19, and you could actually buy shares in Evolution for less than half of that. See the price graph from Börsdata.se below.

How did we figure out that we would earn around 15% if we bought at 700 SEK? We used a valuation method called the Discounted Cash Flow analysis, or simply the DCF.

One of us has a background of studying engineering and finance, and one of the useful things to learn at the university was the method where you could estimate the value of a stock.

The university also teached the Efficient Market Hypothesis, which is hard to learn in theory, and has beautiful models connected to it, but I was sceptical if it was going to be useful in trying to do well with stocks.

The efficient-market hypothesis is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

Warren Buffett and Charlie Munger have always said that what they teach in the university about the Efficient Market Hypothesis and Theory is not how the real world works. But it does give them an advantage if all the smart guys believe that it’s impossible to beat the market.

Nevertheless, the DCF method taught at the university does make sense, and Buffett also endorses it.

A business is worth what it produces for you, and you can calculate that by figuring out what cash flows the business will give you. When you will get it, how much will you get, and then discount it back to the present day with an appropriate discount factor. The idea is that the cash flow that you get many years from now is not as valuable for you as the cash that you will get today.

Those of you who will follow us the most in the future will certainly get the opportunity to learn the method we speak about. You can then figure out the value of a stock and compare it to the market price that the stock market presents to you every day. Sometimes it is possible to buy stocks at half of what they are worth, like we figured out with Evolution a year ago.

Let us show you a glimpse of what we did.

As you can see from Börsdata.se, the cash flow growth that Evolution is producing is astonishing. 

The free cash flow that you get from the business is close to what we use in our DCF model. We call it the Owner’s Earnings. Owner’s Earnings is the cash that you can get back from the business that is what the owners can keep. We’ll be writing more about how this works in future articles.

When we have estimated the Owner’s Earnings in the future and its growth, we can discount the cash flows back and figure out what they are worth in total.

In the model below we are assuming a future growth in 2021 of around 50%. That is quite a guess and we may be far off. And we continue to guess that the cash flows will continue to grow, but that the growth will get slower over the next five years until we have a steady growth of 10% for the following five years. In ten years time or so we guess that the Owner’s Earnings will only grow 5% or so in the future. It might be a conservative estimate. It’s not easy to tell, but we adjust our required return so that we have a large margin of safety if we are going to be wrong. An excerpt from the model is shown below:

As you can see, with the assumptions we have laid out we get an intrinsic value of around 700 per share (it was a bit higher previously because the Euro was stronger against the SEK). See the value in the green cell. The yellow cells are just estimates.

We get an intrinsic value of around 700 SEK per share when we use a discount rate of 15%. To us, that means that we can expect to get 15% per year on our money if we invest in Evolution at 700 SEK or lower per share. We were quite happy to add to our position at 300 and 600 then.

But what do we think we will earn on our money from now on, when the shares are trading close to 1225 SEK per share?

As the model suggests, if the estimated growth of 50% next year pans out, and with a quite high growth but declining in the years to follow, we’d still get a decent return on our money today.

Notice that the Discount rate has been changed from 15% to 9%.

The model suggests that you’d get around 9% on your investment if the cash flows and owner’s earnings are correctly estimated. That’s a wild guess, but we have a ballpark estimation, and a range to look at.

Note that the model assumes that the business can be sold for 15 times cash flows in the future when the business growth has dropped to around 5% only. Also a big guess.

What if the business will grow faster than we estimate? What’s our estimated return then?

If we bump the 2021 growth rate up from 50% to 80%, and increase it a bit more into the close future, we’d get an intrinsic value of around today’s price with a discount rate of 12%. 

That means that if the company grows 80% instead of 50% in 2021, 60% instead of 40% in 2022 and so on, you’d get around 12% on your money now instead of 9%.

This tells us that the company really needs to grow quite substantially to defend today’s valuation. It might pan out, and we might be wrong. Nevertheless, the really huge upside was when we could buy the shares a year ago and earlier.

What cash flows do I need to double my money if my required rate of return is 10%?

It’s another guess, but it could look like this:

As we see from the historical cash flow growth, they have done similar growth the last few years. It’s not impossible that the stock could be worth twice today's price and you’d still get 10% on your investment. It’d require growth rates to stay as high as they have been the last year, and that they won’t fall that quickly.

Is Evolution still overpriced?

We’re happy holding most of our position still, because it’s a really wonderful business, and we believe the growth will be high. We think the stock is fairly priced now, and we still think you can get around 10% on your investment if the scenario of at least 50% growth next year pans out. It’s hard for us to tell how much the growth will be. It depends on the market, and by that we mean the customer growth. But if the market is there, we believe it is such a wonderful business that it is able to compete well for the market share for sure.