Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Ero Copper Corp (TSE:ERO) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not September 2018 then I highly recommend you check out the latest calculation for Ero Copper by following the link below.
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 five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow forecast
|Levered FCF ($, Millions)||$63.98||$85.69||$136.48||$130.38||$151.24|
|Source||Analyst x5||Analyst x5||Analyst x3||Analyst x2||Est @ 16%, capped from 75.75%|
|Present Value Discounted @ 17.66%||$54.37||$61.90||$83.79||$68.03||$67.07|
Present Value of 5-year Cash Flow (PVCF)= US$335.2m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.3%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 17.7%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$151.2m × (1 + 2.3%) ÷ (17.7% – 2.3%) = US$1.01b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$1.01b ÷ ( 1 + 17.7%)5 = US$448.0m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$783.2m. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value in the company’s reported currency of $9.27. However, ERO’s primary listing is in Canada, and 1 share of ERO in USD represents 1.309 ( USD/ CAD) share of TSX:ERO, so the intrinsic value per share in CAD is CA$12.13. Compared to the current share price of CA$8.72, the stock is about right, perhaps slightly undervalued at a 28.1% discount to what it is available for right now.
I’d like to 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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Ero Copper as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 17.7%, which is based on a levered beta of 2. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For ERO, I’ve put together three pertinent factors you should further research:
- Financial Health: Does ERO have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does ERO’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: Are there other high quality stocks you could be holding instead of ERO? 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 does a DCF calculation for every CA stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.