Key Insights

Lottery's estimated fair value is AU$4.58 based on 2 Stage Free Cash Flow to Equity Current share price of AU$5.02 suggests Lottery is potentially trading close to its fair value Our fair value estimate is 16% lower than Lottery's analyst price target of AU$5.42

Does the December share price for The Lottery Corporation Limited (ASX:TLC) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Lottery

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 begin with, we have to get estimates of 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 Levered FCF (A$, Millions)  AU$495.2m AU$497.8m AU$531.2m AU$541.0m AU$570.0m AU$591.3m AU$611.3m AU$630.5m AU$649.3m AU$667.9m Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x6 Analyst x1 Analyst x1 Est @ 3.73% Est @ 3.39% Est @ 3.15% Est @ 2.98% Est @ 2.86% Present Value (A$, Millions) Discounted @ 7.7%  AU$460 AU$429 AU$425 AU$402 AU$393 AU$379 AU$363 AU$348 AU$333 AU$318

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$3.8b

Story Continues

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 (2.6%) 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 7.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = AU$668m× (1 + 2.6%) ÷ (7.7%– 2.6%) = AU$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$13b÷ ( 1 + 7.7%)10= AU$6.3b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$10b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$5.0, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.ASX:TLC Discounted Cash Flow December 30th 2024

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Lottery 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 7.7%, which is based on a levered beta of 1.247. 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 Lottery

Strength

Earnings growth over the past year exceeded the industry.

Debt is well covered by earnings and cashflows.

Weakness

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

Opportunity

Annual earnings are forecast to grow for the next 3 years.

Good value based on P/E ratio compared to estimated Fair P/E ratio.

Significant insider buying over the past 3 months.

Threat

Dividends are not covered by cash flow.

Annual earnings are forecast to grow slower than the Australian market.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Lottery, we've compiled three pertinent aspects you should explore:

Risks: Every company has them, and we've spotted  2 warning signs for Lottery  you should know about. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for TLC's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

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

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.

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