Stock Analysis

Exco Technologies Limited's (TSE:XTC) Intrinsic Value Is Potentially 23% Below Its Share Price

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TSX:XTC
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Exco Technologies Limited (TSE:XTC) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Exco Technologies

The method

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 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) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (CA$, Millions) CA$28.7m CA$31.0m CA$27.1m CA$24.8m CA$23.4m CA$22.6m CA$22.2m CA$22.0m CA$22.0m CA$22.1m
Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ -12.74% Est @ -8.46% Est @ -5.46% Est @ -3.36% Est @ -1.89% Est @ -0.86% Est @ -0.14% Est @ 0.36%
Present Value (CA$, Millions) Discounted @ 8.7% CA$26.4 CA$26.2 CA$21.1 CA$17.7 CA$15.4 CA$13.7 CA$12.4 CA$11.3 CA$10.4 CA$9.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$164m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$22m× (1 + 1.5%) ÷ (8.7%– 1.5%) = CA$313m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$313m÷ ( 1 + 8.7%)10= CA$136m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$300m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$10.0, the company appears reasonably expensive at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
TSX:XTC Discounted Cash Flow April 20th 2021

The assumptions

Now 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 Exco Technologies 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 8.7%, which is based on a levered beta of 1.367. 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.

Moving On:

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. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a premium to intrinsic value? For Exco Technologies, there are three additional elements you should further research:

  1. Risks: For example, we've discovered 2 warning signs for Exco Technologies that you should be aware of before investing here.
  2. Future Earnings: How does XTC's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
  3. 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 Canadian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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