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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ATCO Ltd. (TSE:ACO.X) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Crunching the numbers
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (CA$, Millions)||CA$470.0m||CA$563.0m||CA$555.9m||CA$553.8m||CA$555.0m||CA$558.7m||CA$564.1m||CA$570.6m||CA$578.2m||CA$586.4m|
|Growth Rate Estimate Source||Analyst x2||Analyst x1||Est @ -1.26%||Est @ -0.38%||Est @ 0.23%||Est @ 0.66%||Est @ 0.96%||Est @ 1.17%||Est @ 1.32%||Est @ 1.42%|
|Present Value (CA$, Millions) Discounted @ 7.2%||CA$439||CA$490||CA$452||CA$420||CA$393||CA$369||CA$348||CA$328||CA$310||CA$294|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.8b
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 (1.7%) 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 7.2%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$586m× (1 + 1.7%) ÷ (7.2%– 1.7%) = CA$11b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$11b÷ ( 1 + 7.2%)10= CA$5.4b
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$9.3b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$40.6, the company appears quite undervalued at a 50% 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.
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. 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 ATCO 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 7.2%, which is based on a levered beta of 0.915. 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.
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. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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 ATCO, we've put together three important items you should further research:
- Risks: For instance, we've identified 3 warning signs for ATCO (2 are potentially serious) you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ACO.X's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. 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. 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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