Calculating The Intrinsic Value Of Sleep Country Canada Holdings Inc. (TSE:ZZZ)

Key Insights

• The projected fair value for Sleep Country Canada Holdings is CA$30.77 based on 2 Stage Free Cash Flow to Equity

• With CA$28.04 share price, Sleep Country Canada Holdings appears to be trading close to its estimated fair value

• Our fair value estimate is 11% higher than Sleep Country Canada Holdings' analyst price target of CA$27.67

Does the February share price for Sleep Country Canada Holdings Inc. (TSE:ZZZ) 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

View our latest analysis for Sleep Country Canada Holdings

The Method

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, 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$86.3m	CA$87.0m	CA$76.2m	CA$70.0m	CA$66.4m	CA$64.5m	CA$63.5m	CA$63.2m	CA$63.4m	CA$63.9m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Est @ -12.45%	Est @ -8.12%	Est @ -5.09%	Est @ -2.96%	Est @ -1.48%	Est @ -0.44%	Est @ 0.29%	Est @ 0.80%
Present Value (CA$, Millions) Discounted @ 7.7%	CA$80.1	CA$75.0	CA$60.9	CA$52.0	CA$45.8	CA$41.3	CA$37.7	CA$34.9	CA$32.5	CA$30.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$491m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$64m× (1 + 2.0%) ÷ (7.7%– 2.0%) = CA$1.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$1.1b÷ ( 1 + 7.7%)¹⁰= CA$541m

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$1.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$28.0, the company appears about fair value at a 8.9% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

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 Sleep Country Canada Holdings 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 7.7%, which is based on a levered beta of 1.245. 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 Sleep Country Canada Holdings

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Specialty Retail market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Current share price is below our estimate of fair value.

Threat

• Annual earnings are forecast to grow slower than the Canadian market.

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Sleep Country Canada Holdings, we've put together three important elements you should explore:

1. Risks: Take risks, for example - Sleep Country Canada Holdings has 2 warning signs we think you should be aware of.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ZZZ'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.