Does This Valuation Of CAE Inc. (TSE:CAE) Imply Investors Are Overpaying?

Key Insights

• The projected fair value for CAE is CA$23.52 based on 2 Stage Free Cash Flow to Equity
• CAE's CA$31.43 share price signals that it might be 34% overvalued
• Analyst price target for CAE is CA$36.33, which is 54% above our fair value estimate

Does the April share price for CAE Inc. (TSE:CAE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for CAE

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$238.6m	CA$394.8m	CA$511.4m	CA$485.0m	CA$471.0m	CA$464.0m	CA$461.6m	CA$462.3m	CA$465.3m	CA$469.9m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x4	Analyst x1	Est @ -2.89%	Est @ -1.49%	Est @ -0.52%	Est @ 0.17%	Est @ 0.64%	Est @ 0.98%
Present Value (CA$, Millions) Discounted @ 7.1%	CA$223	CA$344	CA$416	CA$368	CA$334	CA$307	CA$285	CA$266	CA$250	CA$236

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.0b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$470m× (1 + 1.8%) ÷ (7.1%– 1.8%) = CA$8.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$8.9b÷ ( 1 + 7.1%)¹⁰= CA$4.5b

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$7.5b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$31.4, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The 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 CAE 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 7.1%, which is based on a levered beta of 0.907. 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 CAE

Next Steps:

Whilst important, the DCF calculation 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. 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. Why is the intrinsic value lower than the current share price? For CAE, we've compiled three relevant items you should look at:

1. Risks: For instance, we've identified 1 warning sign for CAE that you should be aware of.
2. Future Earnings: How does CAE'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX 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.