Is There An Opportunity With Atlas Engineered Products Ltd.'s (CVE:AEP) 31% Undervaluation?

Key Insights

• The projected fair value for Atlas Engineered Products is CA$1.56 based on 2 Stage Free Cash Flow to Equity
• Atlas Engineered Products is estimated to be 31% undervalued based on current share price of CA$1.07

Today we will run through one way of estimating the intrinsic value of Atlas Engineered Products Ltd. (CVE:AEP) by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Atlas Engineered Products

The 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. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$7.30m	CA$8.80m	CA$8.63m	CA$8.57m	CA$8.56m	CA$8.61m	CA$8.69m	CA$8.79m	CA$8.91m	CA$9.04m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ -1.90%	Est @ -0.79%	Est @ -0.01%	Est @ 0.53%	Est @ 0.91%	Est @ 1.18%	Est @ 1.37%	Est @ 1.50%
Present Value (CA$, Millions) Discounted @ 10%	CA$6.6	CA$7.2	CA$6.4	CA$5.7	CA$5.2	CA$4.7	CA$4.3	CA$4.0	CA$3.6	CA$3.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$51m

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 (1.8%) 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 10%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$9.0m× (1 + 1.8%) ÷ (10%– 1.8%) = CA$106m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$106m÷ ( 1 + 10%)¹⁰= CA$39m

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$90m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$1.1, the company appears quite good value at a 31% 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.

Important Assumptions

Now 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 Atlas Engineered Products 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 10%, which is based on a levered beta of 1.462. 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 Atlas Engineered Products

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Atlas Engineered Products, there are three pertinent items you should consider:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Atlas Engineered Products .
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AEP'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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.