Calculating The Intrinsic Value Of ADF Group Inc. (TSE:DRX)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, ADF Group fair value estimate is CA$6.87

• With CA$6.37 share price, ADF Group appears to be trading close to its estimated fair value

Does the December share price for ADF Group Inc. (TSE:DRX) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

See our latest analysis for ADF Group

The Calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$43.2m	CA$46.3m	CA$26.7m	CA$17.6m	CA$13.5m	CA$11.4m	CA$10.2m	CA$9.53m	CA$9.14m	CA$8.93m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -34.02%	Est @ -23.24%	Est @ -15.69%	Est @ -10.40%	Est @ -6.70%	Est @ -4.11%	Est @ -2.30%
Present Value (CA$, Millions) Discounted @ 7.8%	CA$40.1	CA$39.8	CA$21.3	CA$13.0	CA$9.3	CA$7.3	CA$6.0	CA$5.2	CA$4.6	CA$4.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$151m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (1.9%) 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 7.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$8.9m× (1 + 1.9%) ÷ (7.8%– 1.9%) = CA$155m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$155m÷ ( 1 + 7.8%)¹⁰= CA$73m

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$224m. 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$6.4, the company appears about fair value at a 7.3% 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

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 ADF Group 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 7.8%, which is based on a levered beta of 1.173. 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 ADF Group

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Metals and Mining market.

Opportunity

• Annual revenue is forecast to grow faster than the Canadian market.

• Good value based on P/E ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• No apparent threats visible for DRX.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For ADF Group, there are three fundamental elements you should further research:

1. Financial Health: Does DRX 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.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for DRX'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX 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. 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.