Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Roots Corporation (TSE:ROOT) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in January 2019 so be sure check out the updated calculation by following the link below.
Want to help shape the future of investing tools and platforms? Take the survey and be part of one of the most advanced studies of stock market investors to date.
Crunching the numbers
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF (CA$, Millions)||CA$-7.30||CA$18.43||CA$21.00||CA$24.57||CA$28.50|
|Source||Analyst x3||Analyst x3||Analyst x1||Est @ 17%, capped from 17.15%||Est @ 16%, capped from 17.15%|
|Present Value Discounted @ 11.74%||CA$-6.53||CA$14.76||CA$15.05||CA$15.76||CA$16.36|
Present Value of 5-year Cash Flow (PVCF)= CA$55m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (1.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 11.7%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = CA$29m × (1 + 1.9%) ÷ (11.7% – 1.9%) = CA$297m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CA$297m ÷ ( 1 + 11.7%)5 = CA$170m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CA$226m. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of CA$5.36. Compared to the current share price of CA$3.64, the stock is quite good value at a 32% discount to what it is available for right now.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Roots as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 11.7%, which is based on a levered beta of 1.216. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For ROOT, I’ve compiled three pertinent aspects you should further examine:
- Financial Health: Does ROOT have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does ROOT’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of ROOT? 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 does a DCF calculation for every CA stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.