Are Investors Undervaluing Tricon Residential Inc. (TSE:TCN) By 39%?

By
Simply Wall St
Published
October 04, 2021
TSX:TCN
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Tricon Residential Inc. (TSE:TCN) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Tricon Residential

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, 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$253.1m US$300.2m US$340.7m US$374.4m US$402.1m US$424.8m US$443.5m US$459.3m US$472.9m US$484.8m
Growth Rate Estimate Source Analyst x1 Est @ 18.59% Est @ 13.48% Est @ 9.9% Est @ 7.4% Est @ 5.64% Est @ 4.41% Est @ 3.56% Est @ 2.95% Est @ 2.53%
Present Value ($, Millions) Discounted @ 10.0% US$230 US$248 US$256 US$256 US$250 US$240 US$228 US$215 US$201 US$188

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.3b

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 (1.6%) 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 10.0%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$485m× (1 + 1.6%) ÷ (10.0%– 1.6%) = US$5.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$5.9b÷ ( 1 + 10.0%)10= US$2.3b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$4.6b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$16.9, the company appears quite good value at a 39% 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:TCN Discounted Cash Flow October 4th 2021

Important 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 Tricon Residential 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 10.0%, which is based on a levered beta of 1.919. 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:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize 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. 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. Why is the intrinsic value higher than the current share price? For Tricon Residential, there are three additional elements you should consider:

  1. Risks: For example, we've discovered 4 warning signs for Tricon Residential (2 make us uncomfortable!) that you should be aware of before investing here.
  2. Future Earnings: How does TCN'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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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