An Intrinsic Calculation For Hammond Power Solutions Inc. (TSE:HPS.A) Suggests It's 42% Undervalued

Key Insights

• The projected fair value for Hammond Power Solutions is CA$88.83 based on 2 Stage Free Cash Flow to Equity

• Hammond Power Solutions' CA$51.81 share price signals that it might be 42% undervalued

• Our fair value estimate is 24% higher than Hammond Power Solutions' analyst price target of CA$71.67

In this article we are going to estimate the intrinsic value of Hammond Power Solutions Inc. (TSE:HPS.A) 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.

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 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 Hammond Power Solutions

What's The Estimated Valuation?

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$41.1m	CA$46.9m	CA$49.3m	CA$57.2m	CA$61.7m	CA$65.5m	CA$68.6m	CA$71.3m	CA$73.6m	CA$75.7m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Est @ 7.84%	Est @ 6.05%	Est @ 4.79%	Est @ 3.91%	Est @ 3.30%	Est @ 2.87%
Present Value (CA$, Millions) Discounted @ 7.5%	CA$38.3	CA$40.6	CA$39.6	CA$42.8	CA$42.9	CA$42.3	CA$41.2	CA$39.8	CA$38.2	CA$36.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$402m

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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$76m× (1 + 1.9%) ÷ (7.5%– 1.9%) = CA$1.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$1.4b÷ ( 1 + 7.5%)¹⁰= CA$655m

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$1.1b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$51.8, the company appears quite undervalued at a 42% 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

The 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 Hammond Power Solutions 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 1.137. 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 Hammond Power Solutions

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

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

Opportunity

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

• Good value based on P/E ratio and estimated 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 is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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 Hammond Power Solutions, there are three pertinent elements you should further research:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Hammond Power Solutions (at least 1 which makes us a bit uncomfortable) , and understanding these should be part of your investment process.

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