Is There An Opportunity With Headwater Exploration Inc.'s (TSE:HWX) 33% Undervaluation?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Headwater Exploration Inc. (TSE:HWX) as an investment opportunity 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Headwater Exploration

Is Headwater Exploration fairly valued?

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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CA$, Millions)	CA$116.4m	CA$158.8m	CA$144.0m	CA$139.0m	CA$136.5m	CA$135.4m	CA$135.3m	CA$135.8m	CA$136.8m	CA$138.2m
Growth Rate Estimate Source	Analyst x6	Analyst x5	Analyst x1	Analyst x1	Est @ -1.81%	Est @ -0.8%	Est @ -0.09%	Est @ 0.4%	Est @ 0.75%	Est @ 0.99%
Present Value (CA$, Millions) Discounted @ 6.7%	CA$109	CA$139	CA$118	CA$107	CA$98.5	CA$91.5	CA$85.7	CA$80.6	CA$76.1	CA$72.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$978m

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 6.7%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CA$138m× (1 + 1.6%) ÷ (6.7%– 1.6%) = CA$2.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$2.7b÷ ( 1 + 6.7%)¹⁰= CA$1.4b

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$2.4b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$7.2, the company appears quite good value at a 33% 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

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 Headwater Exploration 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 6.7%, which is based on a levered beta of 1.222. 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:

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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Why is the intrinsic value higher than the current share price? For Headwater Exploration, we've compiled three fundamental aspects you should look at:

1. Risks: As an example, we've found 4 warning signs for Headwater Exploration (1 is potentially serious!) that you need to consider before investing here.
2. Future Earnings: How does HWX'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. 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.