A Look At The Intrinsic Value Of Héroux-Devtek Inc. (TSE:HRX)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Héroux-Devtek Inc. (TSE:HRX) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing 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.

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.

Check out our latest analysis for Héroux-Devtek

Is Héroux-Devtek fairly valued?

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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CA$, Millions)	CA$50.9m	CA$47.2m	CA$39.5m	CA$36.6m	CA$35.0m	CA$34.0m	CA$33.5m	CA$33.3m	CA$33.4m	CA$33.5m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x2	Est @ -7.16%	Est @ -4.55%	Est @ -2.72%	Est @ -1.44%	Est @ -0.55%	Est @ 0.08%	Est @ 0.52%
Present Value (CA$, Millions) Discounted @ 7.5%	CA$47.4	CA$40.9	CA$31.8	CA$27.4	CA$24.4	CA$22.0	CA$20.2	CA$18.7	CA$17.4	CA$16.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$266m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 7.5%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CA$34m× (1 + 1.5%) ÷ (7.5%– 1.5%) = CA$571m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$571m÷ ( 1 + 7.5%)¹⁰= CA$277m

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$543m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$14.2, the company appears about fair value at a 4.8% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Héroux-Devtek 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 7.5%, which is based on a levered beta of 1.140. 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.

Next Steps:

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. 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. For Héroux-Devtek, there are three essential elements you should consider:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Héroux-Devtek (including 1 which can't be ignored) .
2. Future Earnings: How does HRX'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 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!

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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