Estimating The Intrinsic Value Of Avarone Metals Inc. (CSE:AVM.X)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Avarone Metals fair value estimate is CA$0.0088
• Avarone Metals' CA$0.01 share price indicates it is trading at similar levels as its fair value estimate
• Industry average of 31% suggests Avarone Metals' peers are currently trading at a higher premium to fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Avarone Metals Inc. (CSE:AVM.X) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Avarone Metals

The 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$55.5k	CA$55.8k	CA$56.3k	CA$57.0k	CA$57.8k	CA$58.7k	CA$59.7k	CA$60.8k	CA$61.9k	CA$63.0k
Growth Rate Estimate Source	Est @ -0.07%	Est @ 0.53%	Est @ 0.95%	Est @ 1.24%	Est @ 1.45%	Est @ 1.59%	Est @ 1.69%	Est @ 1.77%	Est @ 1.81%	Est @ 1.85%
Present Value (CA$, Millions) Discounted @ 8.6%	CA$0.05	CA$0.05	CA$0.04	CA$0.04	CA$0.04	CA$0.04	CA$0.03	CA$0.03	CA$0.03	CA$0.03

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$380k

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 (1.9%) 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 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$63k× (1 + 1.9%) ÷ (8.6%– 1.9%) = CA$969k

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$969k÷ ( 1 + 8.6%)¹⁰= CA$426k

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$806k. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$0.01, the company appears around fair value at the time of writing. 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.

The Assumptions

Now 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 Avarone Metals 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 8.6%, which is based on a levered beta of 1.327. 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.

SWOT Analysis for Avarone Metals

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. DCF models are not the be-all and end-all of investment valuation. 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 Avarone Metals, we've put together three essential elements you should explore:

1. Risks: As an example, we've found 4 warning signs for Avarone Metals that you need to consider before investing here.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AVM.X's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.