Linamar Corporation (TSE:LNR) Shares Could Be 37% Below Their Intrinsic Value Estimate

Key Insights

• Linamar's estimated fair value is CA$113 based on 2 Stage Free Cash Flow to Equity

• Linamar's CA$71.69 share price signals that it might be 37% undervalued

• Analyst price target for LNR is CA$82.08 which is 27% below our fair value estimate

How far off is Linamar Corporation (TSE:LNR) 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 expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Linamar

The Method

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$340.5m	CA$392.0m	CA$429.9m	CA$461.6m	CA$488.1m	CA$510.7m	CA$530.2m	CA$547.6m	CA$563.5m	CA$578.3m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 9.67%	Est @ 7.36%	Est @ 5.75%	Est @ 4.62%	Est @ 3.83%	Est @ 3.28%	Est @ 2.89%	Est @ 2.62%
Present Value (CA$, Millions) Discounted @ 8.6%	CA$313	CA$332	CA$336	CA$332	CA$323	CA$311	CA$298	CA$283	CA$268	CA$253

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.1b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$578m× (1 + 2.0%) ÷ (8.6%– 2.0%) = CA$8.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$8.9b÷ ( 1 + 8.6%)¹⁰= CA$3.9b

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$7.0b. 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$71.7, the company appears quite undervalued at a 37% 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

Important Assumptions

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 Linamar 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 8.6%, which is based on a levered beta of 1.436. 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 Linamar

Strength

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

• Debt is not viewed as a risk.

Weakness

• Earnings growth over the past year underperformed the Auto Components industry.

• Dividend is low compared to the top 25% of dividend payers in the Auto Components 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 cash flow.

• Annual earnings have declined over the past 5 years.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and 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?" 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 sitting below the intrinsic value? For Linamar, there are three important factors you should further research:

1. Risks: Take risks, for example - Linamar has 1 warning sign we think you should be aware of.

2. Future Earnings: How does LNR'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 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.