Is Take-Two Interactive Software, Inc. (NASDAQ:TTWO) trading at a 50% discount?

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In this article, we’ll estimate the intrinsic value of Take-Two Interactive Software, Inc. (NASDAQ: TTWO) by projecting its future cash flows and then discounting them to present value. One way to do this is to use the discounted cash flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.

Our analysis indicates that TTWO is potentially undervalued!

The calculation

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:

Estimated free cash flow (FCF) over 10 years

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Leveraged FCF ($, millions) $584.1 million $1.19 billion $1.78 billion $1.73 billion $1.92 billion $2.06 billion US$2.18 billion $2.28 billion $2.37 billion $2.44 billion
Growth rate estimate Source Analyst x10 Analyst x11 Analyst x7 Analyst x3 Analyst x2 Is at 7.32% Is at 5.72% Is at 4.6% Is at 3.81% Is at 3.26%
Present value (millions of dollars) discounted at 6.8% $547 $1,000 $1.5k $1,300 $1,400 $1,400 $1,400 $1,300 $1,300 $1,300

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $12 billion

After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 2.0%. We discount terminal cash flows to present value at a cost of equity of 6.8%.

Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $2.4 billion × (1 + 2.0%) ÷ (6.8%–2.0%) = $52 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= US$52 billion ÷ (1 + 6.8%)ten= $27 billion

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $39 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$118, the company appears to be pretty good value at a 50% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

NasdaqGS: TTWO Cash Flow Update October 15, 2022

The hypotheses

Now, 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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Take-Two Interactive Software 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 used 6.8%, which is based on a leveraged beta of 1.032. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Take-Two Interactive Software

Strength
  • Debt is well covered by income.
Weakness
  • Revenues have declined over the past year.
  • Shareholders have been diluted over the past year.
Opportunity
  • Annual earnings are expected to grow faster than the US market.
  • Trading below our estimate of fair value by more than 20%.
Threatens
  • Debt is not well covered by operating cash flow.
  • Turnover should grow by less than 20% per year.

Look forward:

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is the stock price below intrinsic value? For Take-Two Interactive Software, we have compiled three relevant aspects that you should consider in more detail:

  1. Risks: Take risks, for example – Take-Two Interactive Software has 3 warning signs we think you should know.
  2. Future earnings: How does TTWO’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
  3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

Valuation is complex, but we help make it simple.

Find out if Take-Two interactive software is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.

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