Is Toromont Industries Ltd. (TSE:TIH) Expensive For A Reason? A Look At Its Intrinsic Value

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Toromont Industries fair value estimate is CA$90.93

• Toromont Industries' CA$115 share price signals that it might be 26% overvalued

• The CA$127 analyst price target for TIH is 40% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Toromont Industries Ltd. (TSE:TIH) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Toromont Industries

The Model

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. To begin with, we have to get estimates of the next ten years of cash flows. 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$463.0m	CA$447.7m	CA$440.5m	CA$438.0m	CA$438.7m	CA$441.6m	CA$446.1m	CA$451.8m	CA$458.4m	CA$465.6m
Growth Rate Estimate Source	Analyst x3	Analyst x1	Est @ -1.61%	Est @ -0.57%	Est @ 0.16%	Est @ 0.67%	Est @ 1.03%	Est @ 1.28%	Est @ 1.45%	Est @ 1.57%
Present Value (CA$, Millions) Discounted @ 7.3%	CA$432	CA$389	CA$357	CA$331	CA$309	CA$290	CA$273	CA$258	CA$244	CA$231

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.1b

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 (1.9%) 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 7.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$466m× (1 + 1.9%) ÷ (7.3%– 1.9%) = CA$8.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$8.8b÷ ( 1 + 7.3%)¹⁰= CA$4.4b

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$7.5b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$115, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

Now 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 Toromont Industries 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 7.3%, which is based on a levered beta of 1.080. 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 Toromont Industries

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

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

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

Opportunity

• Annual earnings are forecast to grow for the next 2 years.

Threat

• Dividends are not covered by cash flow.

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

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a premium to intrinsic value? For Toromont Industries, we've put together three fundamental elements you should further research:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Toromont Industries .

2. Future Earnings: How does TIH'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.