Estimating The Fair Value Of Ceapro Inc. (CVE:CZO)

Today we will run through one way of estimating the intrinsic value of Ceapro Inc. (CVE:CZO) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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.

View our latest analysis for Ceapro

The calculation

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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CA$, Millions)	CA$3.28m	CA$3.40m	CA$3.50m	CA$3.58m	CA$3.40m	CA$3.48m	CA$3.55m	CA$3.61m	CA$3.68m	CA$3.74m
Growth Rate Estimate Source	Est @ 4.41%	Est @ 3.55%	Est @ 2.95%	Est @ 2.52%	Analyst x1	Est @ 2.23%	Est @ 2.02%	Est @ 1.88%	Est @ 1.78%	Est @ 1.71%
Present Value (CA$, Millions) Discounted @ 6.6%	CA$3.1	CA$3.0	CA$2.9	CA$2.8	CA$2.5	CA$2.4	CA$2.3	CA$2.2	CA$2.1	CA$2.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$25m

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 6.6%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CA$3.7m× (1 + 1.5%) ÷ (6.6%– 1.5%) = CA$75m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$75m÷ ( 1 + 6.6%)¹⁰= CA$40m

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$65m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$0.7, the company appears about fair value at a 20% 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.

The assumptions

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 Ceapro 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 6.6%, which is based on a levered beta of 0.965. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Ceapro, we've compiled three important aspects you should explore:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Ceapro (at least 1 which is potentially serious) , and understanding these should be part of your investment process.
2. Future Earnings: How does CZO'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSXV every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St is general in nature. 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.
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