How far off is Big Rock Brewery Inc. (TSE:BR) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present 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.
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're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (CA$, Millions)||CA$2.81m||CA$2.81m||CA$2.81m||CA$2.83m||CA$2.86m||CA$2.89m||CA$2.92m||CA$2.96m||CA$3.00m||CA$3.05m|
|Growth Rate Estimate Source||Est @ -1.05%||Est @ -0.27%||Est @ 0.27%||Est @ 0.65%||Est @ 0.92%||Est @ 1.11%||Est @ 1.24%||Est @ 1.33%||Est @ 1.39%||Est @ 1.44%|
|Present Value (CA$, Millions) Discounted @ 5.9%||CA$2.7||CA$2.5||CA$2.4||CA$2.3||CA$2.1||CA$2.1||CA$2.0||CA$1.9||CA$1.8||CA$1.7|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$21m
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 5.9%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$3.0m× (1 + 1.5%) ÷ (5.9%– 1.5%) = CA$72m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$72m÷ ( 1 + 5.9%)10= CA$41m
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$62m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$7.3, the company appears about fair value at a 18% 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.
Now 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 Big Rock Brewery 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 5.9%, which is based on a levered beta of 0.825. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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. 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. For Big Rock Brewery, there are three essential aspects you should consider:
- Risks: Take risks, for example - Big Rock Brewery has 3 warning signs (and 1 which is potentially serious) we think you should know about.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks just search here.
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