Is There An Opportunity With Canadian Tire Corporation, Limited's (TSE:CTC.A) 28% Undervaluation?

Key Insights

• Canadian Tire Corporation's estimated fair value is CA$195 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$141 suggests Canadian Tire Corporation is potentially 28% undervalued

• Our fair value estimate is 19% higher than Canadian Tire Corporation's analyst price target of CA$164

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Canadian Tire Corporation, Limited (TSE:CTC.A) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Canadian Tire Corporation

Is Canadian Tire Corporation Fairly Valued?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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$848.0m	CA$895.0m	CA$893.0m	CA$900.0m	CA$901.0m	CA$907.0m	CA$916.7m	CA$929.0m	CA$943.3m	CA$959.0m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Est @ 0.67%	Est @ 1.06%	Est @ 1.34%	Est @ 1.54%	Est @ 1.67%
Present Value (CA$, Millions) Discounted @ 9.6%	CA$774	CA$746	CA$679	CA$625	CA$571	CA$524	CA$484	CA$447	CA$415	CA$385

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$5.6b

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 9.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$959m× (1 + 2.0%) ÷ (9.6%– 2.0%) = CA$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$13b÷ ( 1 + 9.6%)¹⁰= CA$5.2b

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$11b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$141, the company appears a touch undervalued at a 28% 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.

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. 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 Canadian Tire Corporation 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 9.6%, which is based on a levered beta of 1.646. 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 Canadian Tire Corporation

Strength

• Debt is well covered by earnings.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Multiline Retail market.

Opportunity

• Annual earnings are forecast to grow faster than the Canadian market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Debt is not well covered by operating cash flow.

• Annual revenue is forecast to grow slower than the Canadian market.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Canadian Tire Corporation, we've compiled three relevant aspects you should explore:

1. Risks: For example, we've discovered 3 warning signs for Canadian Tire Corporation (1 is significant!) that you should be aware of before investing here.

2. Future Earnings: How does CTC.A'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 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.

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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.