In this article we are going to estimate the intrinsic value of WSP Global Inc. (TSE:WSP) by taking the expected future cash flows and discounting them to today's value. This will be done using 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.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.
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
|Levered FCF (CA$, Millions)||CA$413.2m||CA$545.3m||CA$614.0m||CA$663.6m||CA$704.3m||CA$737.8m||CA$765.7m||CA$789.6m||CA$810.4m||CA$829.1m|
|Growth Rate Estimate Source||Analyst x5||Analyst x5||Analyst x2||Est @ 8.09%||Est @ 6.13%||Est @ 4.75%||Est @ 3.79%||Est @ 3.11%||Est @ 2.64%||Est @ 2.31%|
|Present Value (CA$, Millions) Discounted @ 7.2%||CA$386||CA$475||CA$499||CA$503||CA$499||CA$487||CA$472||CA$454||CA$435||CA$416|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$4.6b
The second stage is also known as Terminal Value, this is the business's cash flow after 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 7.2%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$829m× (1 + 1.5%) ÷ (7.2%– 1.5%) = CA$15b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$15b÷ ( 1 + 7.2%)10= CA$7.5b
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$12b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$115, 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 WSP Global 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 7.2%, which is based on a levered beta of 1.073. 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. The DCF model is not a perfect stock valuation tool. 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. For WSP Global, we've compiled three additional elements you should look at:
- Risks: Case in point, we've spotted 2 warning signs for WSP Global you should be aware of.
- Future Earnings: How does WSP'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 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. 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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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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