Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Questor Technology Inc. (CVE:QST) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!
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. If you still have some burning questions about this type of valuation, take a look at 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) forecast
|Levered FCF (CA$, Millions)||CA$1.24m||CA$6.00m||CA$6.92m||CA$7.70m||CA$8.35m||CA$8.88m||CA$9.32m||CA$9.69m||CA$10.0m||CA$10.3m|
|Growth Rate Estimate Source||Analyst x3||Analyst x1||Est @ 15.38%||Est @ 11.27%||Est @ 8.38%||Est @ 6.37%||Est @ 4.95%||Est @ 3.97%||Est @ 3.27%||Est @ 2.79%|
|Present Value (CA$, Millions) Discounted @ 9.6%||CA$1.1||CA$5.0||CA$5.3||CA$5.3||CA$5.3||CA$5.1||CA$4.9||CA$4.7||CA$4.4||CA$4.1|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$45m
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 (1.7%) 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 9.6%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$10m× (1 + 1.7%) ÷ (9.6%– 1.7%) = CA$132m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$132m÷ ( 1 + 9.6%)10= CA$53m
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$98m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$2.3, the company appears quite good value at a 36% 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.
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. 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 Questor Technology 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 9.6%, which is based on a levered beta of 1.318. 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 shouldn't be the only metric you look at when researching 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. Why is the intrinsic value higher than the current share price? For Questor Technology, there are three pertinent aspects you should assess:
- Risks: We feel that you should assess the 4 warning signs for Questor Technology we've flagged before making an investment in the company.
- Future Earnings: How does QST'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 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. 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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