An Intrinsic Calculation For Finning International Inc. (TSE:FTT) Suggests It's 42% Undervalued

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Finning International fair value estimate is CA$67.26

• Current share price of CA$38.99 suggests Finning International is potentially 42% undervalued

• Our fair value estimate is 39% higher than Finning International's analyst price target of CA$48.22

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 taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Finning International

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 begin with, we have to get estimates of 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$533.7m	CA$580.3m	CA$615.0m	CA$644.3m	CA$669.5m	CA$691.8m	CA$711.8m	CA$730.4m	CA$748.0m	CA$764.9m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ 5.98%	Est @ 4.76%	Est @ 3.91%	Est @ 3.32%	Est @ 2.90%	Est @ 2.61%	Est @ 2.41%	Est @ 2.26%
Present Value (CA$, Millions) Discounted @ 8.4%	CA$492	CA$494	CA$483	CA$467	CA$447	CA$426	CA$405	CA$383	CA$362	CA$342

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$4.3b

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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$765m× (1 + 1.9%) ÷ (8.4%– 1.9%) = CA$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$12b÷ ( 1 + 8.4%)¹⁰= CA$5.4b

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$9.7b. 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$39.0, the company appears quite good value at a 42% 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.

TSX:FTT Discounted Cash Flow January 13th 2024

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 8.4%, which is based on a levered beta of 1.293. 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

• Earnings growth over the past year is below its 5-year average.

• 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 3 years.

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

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

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

Next Steps:

Whilst important, the DCF calculation 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Finning International, we've put together three further elements you should further research:

1. Risks: We feel that you should assess the 2 warning signs for Finning International (1 shouldn't be ignored!) we've flagged before making an investment in the company.

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 High Quality Alternatives: Do you like a good all-rounder? 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 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.

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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.