A Look At The Intrinsic Value Of Spectra Products Inc. (CVE:SSA)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Spectra Products fair value estimate is CA$0.25
• With CA$0.27 share price, Spectra Products appears to be trading close to its estimated fair value
• Peers of Spectra Products are currently trading on average at a 47% discount

In this article we are going to estimate the intrinsic value of Spectra Products Inc. (CVE:SSA) by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Spectra Products

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$324.3k	CA$290.2k	CA$270.5k	CA$259.1k	CA$252.9k	CA$250.1k	CA$249.6k	CA$250.6k	CA$252.7k	CA$255.6k
Growth Rate Estimate Source	Est @ -15.81%	Est @ -10.51%	Est @ -6.80%	Est @ -4.20%	Est @ -2.38%	Est @ -1.11%	Est @ -0.22%	Est @ 0.40%	Est @ 0.84%	Est @ 1.15%
Present Value (CA$, Millions) Discounted @ 8.2%	CA$0.3	CA$0.2	CA$0.2	CA$0.2	CA$0.2	CA$0.2	CA$0.1	CA$0.1	CA$0.1	CA$0.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.8m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$256k× (1 + 1.9%) ÷ (8.2%– 1.9%) = CA$4.1m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$4.1m÷ ( 1 + 8.2%)¹⁰= CA$1.9m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$3.7m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$0.3, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important Assumptions

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 evaluation of a company's future performance, so try the calculation yourself and check your own 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 Spectra Products 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 8.2%, which is based on a levered beta of 1.269. 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.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Spectra Products, we've compiled three further aspects you should further research:

1. Risks: Be aware that Spectra Products is showing 3 warning signs in our investment analysis , and 2 of those don't sit too well with us...
2. 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!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSXV every day. If you want to find the calculation for other stocks just search here.

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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.