Are Quarterhill Inc. (TSE:QTRH) Investors Paying Above The Intrinsic Value?
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Quarterhill fair value estimate is CA$1.38
Quarterhill's CA$1.84 share price signals that it might be 34% overvalued
Our fair value estimate is 20% lower than Quarterhill's analyst price target of CA$1.72
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Quarterhill Inc. (TSE:QTRH) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
See our latest analysis for Quarterhill
Is Quarterhill Fairly Valued?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF (CA$, Millions) | CA$15.0m | CA$12.6m | CA$11.2m | CA$10.4m | CA$9.98m | CA$9.73m | CA$9.62m | CA$9.60m | CA$9.65m | CA$9.73m |
Growth Rate Estimate Source | Analyst x1 | Est @ -16.25% | Est @ -10.79% | Est @ -6.98% | Est @ -4.30% | Est @ -2.43% | Est @ -1.12% | Est @ -0.21% | Est @ 0.43% | Est @ 0.88% |
Present Value (CA$, Millions) Discounted @ 7.6% | CA$13.9 | CA$10.8 | CA$9.0 | CA$7.8 | CA$6.9 | CA$6.3 | CA$5.7 | CA$5.3 | CA$5.0 | CA$4.7 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$75m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (1.9%) 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 7.6%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CA$9.7m× (1 + 1.9%) ÷ (7.6%– 1.9%) = CA$173m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$173m÷ ( 1 + 7.6%)10= CA$83m
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$158m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$1.8, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Quarterhill 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 7.6%, which is based on a levered beta of 1.144. 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 Quarterhill
Strength
Debt is well covered by earnings.
Weakness
No major weaknesses identified for QTRH.
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.
Significant insider buying over the past 3 months.
Threat
Debt is not well covered by operating cash flow.
Annual revenue is expected to decline over the next 3 years.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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?" 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 exceeding the intrinsic value? For Quarterhill, we've put together three important items you should look at:
Risks: We feel that you should assess the 1 warning sign for Quarterhill we've flagged before making an investment in the company.
Future Earnings: How does QTRH'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 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.
