A Look At The Fair Value Of Fortis Inc. (TSE:FTS)
Today we will run through one way of estimating the intrinsic value of Fortis Inc. (TSE:FTS) by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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 Fortis
Crunching The Numbers
As Fortis operates in the electric utilities sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.8%. We then discount this figure to today's value at a cost of equity of 6.5%. Compared to the current share price of CA$53.6, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)
= CA$2.4 / (6.5% – 1.8%)
= CA$50.8
Important 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 Fortis 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 6.5%, which is based on a levered beta of 0.800. 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 Fortis
Strength
Earnings growth over the past year exceeded its 5-year average.
Weakness
Earnings growth over the past year underperformed the Electric Utilities industry.
Interest payments on debt are not well covered.
Dividend is low compared to the top 25% of dividend payers in the Electric Utilities market.
Opportunity
Annual earnings are forecast to grow faster than the Canadian market.
Good value based on P/E ratio compared to estimated Fair P/E ratio.
Threat
Debt is not well covered by operating cash flow.
Paying a dividend but company has no free cash flows.
Annual revenue is forecast to grow slower than the Canadian market.
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. DCF models are not the be-all and end-all of investment valuation. 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. 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. For Fortis, we've compiled three further factors you should consider:
Risks: For instance, we've identified 2 warning signs for Fortis (1 is significant) you should be aware of.
Future Earnings: How does FTS'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.
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.
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