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Are Investors Undervaluing North American Construction Group Ltd. (TSE:NOA) By 31%?

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·5 min read
In this article:
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  • NOA

In this article we are going to estimate the intrinsic value of North American Construction Group Ltd. (TSE:NOA) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for North American Construction Group

The model

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

10-year free cash flow (FCF) forecast

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (CA$, Millions)

CA$76.0m

CA$74.0m

CA$73.1m

CA$72.8m

CA$72.9m

CA$73.3m

CA$73.9m

CA$74.7m

CA$75.6m

CA$76.6m

Growth Rate Estimate Source

Analyst x2

Analyst x2

Est @ -1.26%

Est @ -0.42%

Est @ 0.16%

Est @ 0.57%

Est @ 0.86%

Est @ 1.06%

Est @ 1.2%

Est @ 1.3%

Present Value (CA$, Millions) Discounted @ 11%

CA$68.5

CA$60.1

CA$53.5

CA$48.0

CA$43.3

CA$39.3

CA$35.7

CA$32.5

CA$29.6

CA$27.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$437m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA$77m× (1 + 1.5%) ÷ (11%– 1.5%) = CA$824m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$824m÷ ( 1 + 11%)10= CA$291m

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$728m. 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$17.7, the company appears quite good value at a 31% 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.

dcf
dcf

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 North American Construction Group 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 11%, which is based on a levered beta of 2.000. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. 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. Why is the intrinsic value higher than the current share price? For North American Construction Group, we've compiled three fundamental aspects you should assess:

  1. Risks: Be aware that North American Construction Group is showing 2 warning signs in our investment analysis , and 1 of those is significant...

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for NOA's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.