Stock Analysis

A Look At The Fair Value Of Sparta Capital Ltd. (CVE:SAY)

TSXV:SAY
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Sparta Capital Ltd. (CVE:SAY) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Sparta Capital

What's the estimated valuation?

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. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (CA$, Millions) CA$870.8k CA$1.26m CA$1.65m CA$2.02m CA$2.35m CA$2.63m CA$2.85m CA$3.04m CA$3.20m CA$3.32m
Growth Rate Estimate Source Est @ 62.54% Est @ 44.24% Est @ 31.43% Est @ 22.46% Est @ 16.19% Est @ 11.79% Est @ 8.72% Est @ 6.56% Est @ 5.06% Est @ 4%
Present Value (CA$, Millions) Discounted @ 7.1% CA$0.8 CA$1.1 CA$1.3 CA$1.5 CA$1.7 CA$1.7 CA$1.8 CA$1.8 CA$1.7 CA$1.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$15m

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. 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 7.1%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$3.3m× (1 + 1.5%) ÷ (7.1%– 1.5%) = CA$60m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$60m÷ ( 1 + 7.1%)10= CA$30m

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$45m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$0.2, the company appears about fair value at a 17% 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.

dcf
TSXV:SAY Discounted Cash Flow March 4th 2021

Important 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 Sparta Capital 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 1.070. 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.

Moving On:

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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Sparta Capital, we've compiled three important items you should further research:

  1. Risks: For instance, we've identified 6 warning signs for Sparta Capital (2 make us uncomfortable) you should be aware of.
  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 Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

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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