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An Intrinsic Calculation For Finning International Inc. (TSE:FTT) Suggests It's 36% Undervalued

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Finning International fair value estimate is CA$55.40

  • Finning International's CA$35.18 share price signals that it might be 36% undervalued

  • Analyst price target for FTT is CA$43.00 which is 22% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Finning International Inc. (TSE:FTT) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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 Finning International

The Method

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF (CA$, Millions)

CA$678.0m

CA$499.7m

CA$565.0m

CA$612.7m

CA$652.1m

CA$684.9m

CA$712.6m

CA$736.6m

CA$757.8m

CA$777.1m

Growth Rate Estimate Source

Analyst x3

Analyst x3

Analyst x1

Est @ 8.44%

Est @ 6.43%

Est @ 5.03%

Est @ 4.05%

Est @ 3.36%

Est @ 2.88%

Est @ 2.55%

Present Value (CA$, Millions) Discounted @ 9.4%

CA$620

CA$418

CA$432

CA$428

CA$417

CA$400

CA$381

CA$360

CA$339

CA$318

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$4.1b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CA$777m× (1 + 1.8%) ÷ (9.4%– 1.8%) = CA$10b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$10b÷ ( 1 + 9.4%)10= CA$4.3b

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 CA$8.4b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$35.2, the company appears quite good value at a 36% discount to where the stock price trades currently. 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.

dcf
dcf

Important Assumptions

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 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 Finning International 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 9.4%, which is based on a levered beta of 1.280. 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 Finning International

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is well covered by earnings.

Weakness

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

Opportunity

  • Annual earnings are forecast to grow for the next 2 years.

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

Threat

  • Debt is not well covered by operating cash flow.

  • Paying a dividend but company has no free cash flows.

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

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Finning International, there are three further factors you should consider:

  1. Risks: For example, we've discovered 2 warning signs for Finning International (1 can't be ignored!) that you should be aware of before investing here.

  2. Future Earnings: How does FTT'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. 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.

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.

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