Does the September share price for Hardwoods Distribution Inc. (TSE: HDI) reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by projecting its future cash flows, then discounting them to today’s value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
Check out our latest review for Hardwoods Distribution
Crunch the numbers
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 a lower growth stage. To begin with, we need to estimate the next ten years of cash flow. 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) forecast
|Leverage FCF ($, Millions)||US $ 67.7 million||US $ 63.9 million||US $ 61.7 million||US $ 60.5 million||US $ 59.9 million||$ 59.8 million||US $ 60.0 million||US $ 60.4 million||US $ 61.0 million||US $ 61.6 million|
|Source of growth rate estimate||Analyst x4||Is @ -5.62%||Is @ -3.48%||Est @ -1.97%||East @ -0.92%||Est @ -0.19%||Is @ 0.33%||East @ 0.69%||Est @ 0.94%||Est @ 1.12%|
|Present value (in millions of dollars) discounted at 7.6%||US $ 62.9||US $ 55.2||US $ 49.6||US $ 45.2||US $ 41.6||US $ 38.6||US $ 36.0||US $ 33.7||US $ 31.7||$ 29.8|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 424 million
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount the terminal cash flows to their present value at a cost of equity of 7.6%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 62 million × (1 + 1.5%) ÷ (7.6% to 1.5%) = US $ 1.0 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 1.0 billion ÷ (1 + 7.6%)ten= US $ 502 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $ 926 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current share price of C $ 39.2, the company appears to be slightly undervalued at a 29% discount from the current share 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. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 consider Hardwoods Distribution 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 into account debt. In this calculation, we used 7.6%, which is based on a leveraged beta of 1.276. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
To move on :
While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for 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?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. What is the reason why the stock price is below intrinsic value? For the distribution of hardwoods, there are three critical factors you should research further:
- Risks: For example, we have identified 4 warning signs for the distribution of hardwoods (2 are of concern) you should be aware of.
- Management: Have insiders increased their stocks to take advantage of market sentiment about HDI’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of another stock just search here.
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 documents. Simply Wall St has no position in the mentioned stocks.
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