Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of First Quantum Minerals Ltd. (TSE:FM) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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. To start off with, we need to estimate 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) estimate
|Levered FCF ($, Millions)||US$680.8m||US$719.7m||US$531.4m||-US$645.2m||US$655.6m||US$560.2m||US$505.5m||US$473.2m||US$454.1m||US$443.2m|
|Growth Rate Estimate Source||Analyst x7||Analyst x7||Analyst x7||Analyst x2||Analyst x1||Est @ -14.55%||Est @ -9.75%||Est @ -6.4%||Est @ -4.05%||Est @ -2.4%|
|Present Value ($, Millions) Discounted @ 11%||US$613||US$583||US$387||-US$423.1||US$387||US$298||US$242||US$204||US$176||US$154|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.6b
After calculating the present value of future cash flows in the intial 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 10-year government bond rate (1.4%) 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 11%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$443m× (1 + 1.4%) ÷ 11%– 1.4%) = US$4.6b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$4.6b÷ ( 1 + 11%)10= US$1.6b
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$4.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$8.6, the company appears about fair value at a 1.6% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 First Quantum Minerals 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 11%, which is based on a levered beta of 1.780. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For First Quantum Minerals, We’ve compiled three important aspects you should further examine:
- Risks: We feel that you should assess the 2 warning signs for First Quantum Minerals (1 doesn’t sit too well with us!) we’ve flagged before making an investment in the company.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for FM’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every CA stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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