How far off is HEXO Corp. (TSE:HEXO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the foreast future cash flows of the company and discounting them back to today's value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Step by step through the calculation
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.
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
|Levered FCF (CA$, Millions)||-CA$203.6m||-CA$53.3m||-CA$23.8m||-CA$12.3m||CA$12.0m||CA$18.9m||CA$26.7m||CA$34.4m||CA$41.5m||CA$47.7m|
|Growth Rate Estimate Source||Analyst x6||Analyst x6||Analyst x4||Analyst x2||Analyst x1||Est @ 57.71%||Est @ 40.83%||Est @ 29.01%||Est @ 20.74%||Est @ 14.95%|
|Present Value (CA$, Millions) Discounted @ 6.4%||-CA$191.4||-CA$47.1||-CA$19.8||-CA$9.6||CA$8.8||CA$13.0||CA$17.3||CA$20.9||CA$23.8||CA$25.7|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -CA$158.0m
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 10-year government bond rate (1.4%) 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 6.4%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = CA$48m× (1 + 1.4%) ÷ 6.4%– 1.4%) = CA$978m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$978m÷ ( 1 + 6.4%)10= CA$526m
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$368m. 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$0.7, the company appears quite undervalued at a 32% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 HEXO 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 6.4%, which is based on a levered beta of 0.910. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching 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?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For HEXO, We've compiled three additional factors you should further examine:
- Risks: Take risks, for example - HEXO has 4 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
- Future Earnings: How does HEXO'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.
- 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. 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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