Today we are going to review a valuation method used to estimate the attractiveness of Keyera Corp. (TSE: KEY) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Check out our latest analysis for Keyera
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (C $, Millions)||CAN $ 430.4 million||460.1 million Canadian dollars||CAN $ 598.6 million||C $ 632.5 million||C $ 657.9 million||C $ 679.4 million||CA $ 698.0 million||C $ 714.6 million||CA $ 729.8 million||CA $ 744.0 million|
|Source of estimated growth rate||Analyst x6||Analyst x5||Analyst x2||Analyst x2||Is 4.01%||East @ 3.27%||East @ 2.75%||East @ 2.38%||Est @ 2.13%||Est @ 1.95%|
|Present value (CA $, Millions) discounted at 8.9%||CA $ 395||CA $ 388||CA $ 464||CA $ 450||$ 430 CAD||CA $ 408||CA $ 385||CA $ 362||CA $ 340||CA $ 318|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CA $ 3.9 billion
The second stage is also known as terminal value, this is the cash flow of the business after 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 used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 8.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA $ 744M × (1 + 1.5%) ÷ (8.9% – 1.5%) = CA $ 10B
Present value of terminal value (PVTV)= TV / (1 + r)ten= CA $ 10B ÷ (1 + 8.9%)ten= CA $ 4.4 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is C $ 8.3 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current stock price of C $ 30.8, the company appears to be roughly at fair value with an 18% discount from the current stock price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Keyera 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 takes debt into account. In this calculation, we used 8.9%, which is based on a leveraged beta of 1.555. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Keyera, we’ve compiled three more factors to consider:
- Risks: We think you should evaluate the 5 warning signs for Keyera (1 cannot be ignored!) We reported before making an investment in the business.
- Management: Have insiders increased their stocks to take advantage of market sentiment about KEY’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow valuation for each share on the TSX. If you want to find the calculation for other actions, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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