Today we’re going to review one way to estimate the intrinsic value of Burcon NutraScience Corporation (TSE: BU) by projecting its future cash flows, then discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
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 want to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St analysis model.
See our latest review for Burcon NutraScience
We are going to use a two-step DCF model, which, as the name suggests, takes into account two growth stages. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. 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, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year free cash flow (FCF) forecast
|Leverage FCF (C $, Millions)||-2.24 million Canadian dollars||– CA $ 1.83 M||CA $ 844.0k||CAN $ 4.15 million||C $ 6.97 million||C $ 10.3 million||13.8 million Canadian dollars||C $ 17.2 million||20.2 million Canadian dollars||22.8 million Canadian dollars|
|Source of growth rate estimate||Analyst x1||Analyst x1||Analyst x1||Analyst x1||Est @ 67.91%||Is at 48%||Est @ 34.06%||Is 24.3%||East @ 17.47%||Is 12.69%|
|Present value (CA $, millions) discounted at 6.1%||-2.1 $ CA||-1.6 $ CA||CA $ 0.7||CA $ 3.3||CA $ 5.2||CA $ 7.2||CA $ 9.2||CA $ 10.7||CA $ 11.9||CA $ 12.6|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 57 million Canadian dollars
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. 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 6.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA $ 23 million × (1 + 1.5%) ÷ (6.1% – 1.5%) = CA $ 509 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= C $ 509 million ÷ (1 + 6.1%)ten= 283 million Canadian dollars
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is C $ 340 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of C $ 3.2, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
We draw your attention to the fact 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 these entries, I recommend that you redo the calculations yourself and play with them. 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 Burcon NutraScience 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 6.1%, which is based on a leveraged beta of 0.961. 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.
While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Burcon NutraScience, there are three important things you should consider further:
- Risks: For example, we discovered 3 warning signs for Burcon NutraScience (1 cannot be ignored!) Which you should be aware of before investing here.
- Management: Have insiders increased their stocks to take advantage of market sentiment about BU’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 may 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.
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