Today we'll do a simple run through of a valuation method used to estimate the attractiveness of CanWel Building Materials Group Ltd. (TSE:CWX) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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 begin with, we have to get estimates of 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.
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) forecast
|Levered FCF (CA$, Millions)||CA$43.1m||CA$69.9m||CA$83.0m||CA$77.0m||CA$73.6m||CA$71.7m||CA$70.8m||CA$70.4m||CA$70.5m||CA$70.9m|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Analyst x1||Analyst x1||Est @ -4.36%||Est @ -2.59%||Est @ -1.35%||Est @ -0.48%||Est @ 0.12%||Est @ 0.55%|
|Present Value (CA$, Millions) Discounted @ 8.7%||CA$39.7||CA$59.2||CA$64.7||CA$55.2||CA$48.6||CA$43.5||CA$39.5||CA$36.2||CA$33.3||CA$30.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$450m
After calculating the present value of future cash flows in the initial 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 5-year average of the 10-year government bond yield (1.5%) 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 8.7%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$71m× (1 + 1.5%) ÷ (8.7%– 1.5%) = CA$1.0b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$1.0b÷ ( 1 + 8.7%)10= CA$439m
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$889m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$7.8, the company appears quite good value at a 32% discount to where the stock price trades currently. 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 CanWel Building Materials Group 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 1.365. 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.
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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For CanWel Building Materials Group, we've compiled three pertinent elements you should look at:
- Risks: Take risks, for example - CanWel Building Materials Group has 3 warning signs (and 1 which can't be ignored) we think you should know about.
- Future Earnings: How does CWX'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.
- 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.
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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. 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.
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