Estimating The Intrinsic Value Of Canadian Pacific Railway Limited (TSE:CP)

Key Insights

• Canadian Pacific Railway's estimated fair value is CA$96.2 based on 2 Stage Free Cash Flow to Equity
• Current share price of CA$101 suggests Canadian Pacific Railway is trading close to its fair value
• Analyst price target for CP is CA$112 which is 16% above our fair value estimate

How far off is Canadian Pacific Railway Limited (TSE:CP) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Canadian Pacific Railway

Crunching The Numbers

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$3.89b	CA$4.38b	CA$4.82b	CA$5.14b	CA$5.41b	CA$5.63b	CA$5.82b	CA$5.99b	CA$6.14b	CA$6.28b
Growth Rate Estimate Source	Analyst x9	Analyst x6	Analyst x2	Est @ 6.67%	Est @ 5.17%	Est @ 4.13%	Est @ 3.40%	Est @ 2.88%	Est @ 2.53%	Est @ 2.28%
Present Value (CA$, Millions) Discounted @ 7.5%	CA$3.6k	CA$3.8k	CA$3.9k	CA$3.9k	CA$3.8k	CA$3.7k	CA$3.5k	CA$3.4k	CA$3.2k	CA$3.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$36b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$6.3b× (1 + 1.7%) ÷ (7.5%– 1.7%) = CA$110b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$110b÷ ( 1 + 7.5%)¹⁰= CA$54b

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$89b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$101, the company appears around fair value at the time of writing. 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

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. 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 Canadian Pacific Railway 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 7.5%, which is based on a levered beta of 1.038. 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 Canadian Pacific Railway

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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 Canadian Pacific Railway, there are three important items you should explore:

1. Risks: As an example, we've found 1 warning sign for Canadian Pacific Railway that you need to consider before investing here.
2. Future Earnings: How does CP'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.

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.