A Look At The Fair Value Of The North West Company Inc. (TSE:NWC)

In this article we are going to estimate the intrinsic value of The North West Company Inc. (TSE:NWC) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for North West

Is North West 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 start off with, we need to estimate 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CA$, Millions)	CA$97.7m	CA$68.7m	CA$124.5m	CA$100.0m	CA$86.7m	CA$79.1m	CA$74.6m	CA$71.9m	CA$70.5m	CA$69.8m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Est @ -19.64%	Est @ -13.28%	Est @ -8.83%	Est @ -5.71%	Est @ -3.53%	Est @ -2%	Est @ -0.93%
Present Value (CA$, Millions) Discounted @ 5.0%	CA$93.1	CA$62.4	CA$108	CA$82.4	CA$68.1	CA$59.2	CA$53.2	CA$48.9	CA$45.6	CA$43.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$663m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.6%) 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 5.0%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CA$70m× (1 + 1.6%) ÷ (5.0%– 1.6%) = CA$2.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$2.1b÷ ( 1 + 5.0%)¹⁰= CA$1.3b

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$2.0b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$34.1, the company appears about fair value at a 19% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important assumptions

We would point out that 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 North West 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 5.0%, which is based on a levered beta of 0.800. 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.

Looking Ahead:

Although the valuation of a company is important, it 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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 North West, there are three relevant elements you should consider:

1. Risks: Case in point, we've spotted 1 warning sign for North West you should be aware of.
2. Future Earnings: How does NWC'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. 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. 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.