In this article we are going to estimate the intrinsic value of West Fraser Timber Co. Ltd. (TSE:WFG) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
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.
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 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.
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) forecast
|Levered FCF ($, Millions)||US$1.35b||US$967.0m||US$767.4m||US$660.1m||US$598.6m||US$562.3m||US$541.1m||US$529.3m||US$523.7m||US$522.2m|
|Growth Rate Estimate Source||Analyst x3||Analyst x1||Est @ -20.64%||Est @ -13.98%||Est @ -9.32%||Est @ -6.06%||Est @ -3.78%||Est @ -2.18%||Est @ -1.06%||Est @ -0.28%|
|Present Value ($, Millions) Discounted @ 8.0%||US$1.2k||US$829||US$609||US$485||US$407||US$354||US$316||US$286||US$262||US$242|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.0b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.0%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$522m× (1 + 1.6%) ÷ (8.0%– 1.6%) = US$8.2b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$8.2b÷ ( 1 + 8.0%)10= US$3.8b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$8.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$113, the company appears around fair value at the time of writing. 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.
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 West Fraser Timber 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 8.0%, which is based on a levered beta of 1.472. 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.
Although the valuation of a company is important, 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For West Fraser Timber, we've compiled three additional items you should further research:
- Risks: We feel that you should assess the 3 warning signs for West Fraser Timber (2 don't sit too well with us!) we've flagged before making an investment in the company.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for WFG's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. 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.
Valuation is complex, but we're helping make it simple.
Find out whether West Fraser Timber is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
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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.
West Fraser Timber
West Fraser Timber Co. Ltd., a diversified wood products company, engages in manufacturing, selling, marketing, and distributing lumber, engineered wood products, pulp, newsprint, wood chips, and other residuals and renewable energy.
Flawless balance sheet average dividend payer.