An Intrinsic Calculation For Tecsys Inc. (TSE:TCS) Suggests It's 40% Undervalued

Key Insights

• Tecsys' estimated fair value is CA$42.79 based on 2 Stage Free Cash Flow to Equity

• Tecsys is estimated to be 40% undervalued based on current share price of CA$25.50

• The CA$46.75 analyst price target for TCS is 9.3% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Tecsys Inc. (TSE:TCS) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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.

Check out our latest analysis for Tecsys

Crunching The Numbers

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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$500.0k	CA$13.8m	CA$18.8m	CA$23.7m	CA$28.1m	CA$31.9m	CA$35.1m	CA$37.8m	CA$40.0m	CA$41.9m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 36.16%	Est @ 25.87%	Est @ 18.67%	Est @ 13.62%	Est @ 10.10%	Est @ 7.62%	Est @ 5.90%	Est @ 4.68%
Present Value (CA$, Millions) Discounted @ 6.8%	CA$0.5	CA$12.1	CA$15.4	CA$18.2	CA$20.2	CA$21.5	CA$22.2	CA$22.4	CA$22.2	CA$21.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$177m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 6.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$42m× (1 + 1.9%) ÷ (6.8%– 1.9%) = CA$872m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$872m÷ ( 1 + 6.8%)¹⁰= CA$454m

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$631m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$25.5, the company appears quite good value at a 40% 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

The Assumptions

Now 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 Tecsys 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 6.8%, which is based on a levered beta of 0.978. 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 Tecsys

Strength

• Currently debt free.

Weakness

• Earnings declined over the past year.

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

Opportunity

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

• Trading below our estimate of fair value by more than 20%.

Threat

• Dividends are not covered by earnings.

• Revenue is forecast to grow slower than 20% per year.

Moving On:

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 Tecsys, we've compiled three important items you should further examine:

1. Risks: We feel that you should assess the 2 warning signs for Tecsys we've flagged before making an investment in the company.

2. Future Earnings: How does TCS'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.

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.