I am going to run you through how I calculated the intrinsic value of TransCanada (TSX:TRP) by estimating the Future Cash Flows and discounting them to their present value. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity by taking the expected Future Cash Flows and discounting them to their present valye. Don’t get put off by the jargon, the math behind it is actually quite straightforward.Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
If you are reading this and its not January 2017 then I highly recommend you check out the latest calculation for TransCanada by following the link below. View our latest analysis for TransCanada
I’m 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 perpetual stable growth rate. To begin with we have to get estimates of the next 5 years of cash flows, where possible I use analysts estimates but when these aren’t available I have extrapolated the previous Free Cash Flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past 5 years, but capped to a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
Step by step through the calculation
Note the numbers here are in millions apart from the per share values.
5-year cash flow estimate
|Levered FCF (CAD, Millions)||$4,250.00||$4,833.00||$5,359.24||$5,942.77||$6,589.85|
|Source||Analyst x2||Analyst x2||Extrapolated @ (10.89%)||Extrapolated @ (10.89%)||Extrapolated @ (10.89%)|
|Present Value Discounted @ 10.5%||$3,846.15||$3,958.15||$3,972.06||$3,986.02||$4,000.03|
Present value of next 5 years cash flows: $19,762
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the 5 years. The Perpetuity Method (Gordon Formula) is used to calculate Terminal Value at an annual growth rate equal to the 10 year government bond rate of (1.8%).
Terminal Value = FCF2021 × (1 + g) ÷ (Discount Rate – g)
Terminal Value = $6,590 × (1 + 1.8%) ÷ (10.5% – 1.8%)
Terminal value based on the Perpetuity Method where growth (g) = 1.8%: $76,630
Present value of terminal value: $46,514
The total value or equity value is then the sum of of the present value of the cash flows.
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = $19,762 + $46,514 = $66,277
The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number.
Value = Total value / Shares Outstanding ($66,276.71 / 801.97)
Value per share: $82.64
Now when we compare the intrinsic value of 82.64 to the current share price of $60.65 we find TransCanada (TSX:TRP) is a touch undervalued at a 27% discount to what it is available for right now.
I’d like to 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at TransCanada as potential investors the Cost of Equity is used as the discount rate, not the Cost of Capital (or Weighed Average Cost of Capital/ WACC) which accounts for debt.
In this calculation I’ve used 10.5% and this is based on a Levered Beta of 1.061. I’m not going to go into how I calculate the Levered Beta in detail, I used the ‘Bottom up Beta’ method based on the comparable businesses, I also impose a limit between 0.8 and 2 which is a reasonable range for a stable business. Google this if you want to learn more.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. Is TransCanada in a healthy financial condition? What is the reason for the share price to differ from the intrinsic value? See our latest FREE analysis to find out!
PS. Not interested in TRP anymore? Use our free platform to discover stocks undervalued by more than 20% based on their DCF valuation.