Is West Fraser Timber Co. Ltd. (TSE:WFG) Trading At A 43% Discount?

By
Simply Wall St
Published
March 23, 2022
TSX:WFG
Source: Shutterstock

Today we will run through one way of estimating the intrinsic value of West Fraser Timber Co. Ltd. (TSE:WFG) 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. 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. 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 West Fraser Timber

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$1.84b US$1.06b US$1.06b US$1.07b US$1.08b US$1.10b US$1.11b US$1.13b US$1.14b US$1.16b
Growth Rate Estimate Source Analyst x3 Analyst x3 Est @ 0.44% Est @ 0.78% Est @ 1.01% Est @ 1.18% Est @ 1.29% Est @ 1.37% Est @ 1.43% Est @ 1.47%
Present Value ($, Millions) Discounted @ 7.9% US$1.7k US$911 US$848 US$792 US$742 US$695 US$653 US$614 US$577 US$543

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$8.1b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 7.9%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$1.2b× (1 + 1.6%) ÷ (7.9%– 1.6%) = US$19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$19b÷ ( 1 + 7.9%)10= US$8.7b

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$17b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$114, the company appears quite undervalued at a 43% 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.

dcf
TSX:WFG Discounted Cash Flow March 23rd 2022

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 7.9%, which is based on a levered beta of 1.490. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For West Fraser Timber, we've put together three relevant elements you should explore:

  1. Risks: For example, we've discovered 2 warning signs for West Fraser Timber (1 is significant!) that you should be aware of before investing here.
  2. Future Earnings: How does WFG'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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Simply Wall St does a detailed discounted cash flow calculation every 6 hours for every stock on the market, so if you want to find the intrinsic value of any company just search here. It’s FREE.

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