An Intrinsic Calculation For ATCO Ltd. (TSE:ACO.X) Suggests It's 26% Undervalued

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editorial-team@simplywallst.com (Simply Wall St)

Mon, Jan 27, 2025, 4:55 AM 5 min read

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ATCO Ltd. (TSE:ACO.X) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

See our latest analysis for ATCO

Is ATCO Fairly Valued?

We have to calculate the value of ATCO slightly differently to other stocks because it is a integrated utilities company. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. This often underestimates the value of a stock, but it can still be good as a comparison to competitors. We use the Gordon Growth Model, which assumes dividend will grow into perpetuity at a rate that can be sustained. For a number of reasons a very conservative growth rate is used that cannot exceed that of a company's Gross Domestic Product (GDP). In this case we used the 5-year average of the 10-year government bond yield (2.3%). The expected dividend per share is then discounted to today's value at a cost of equity of 5.6%. Compared to the current share price of CA$46.7, the company appears a touch undervalued at a 26% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= CA$2.1 / (5.6% – 2.3%)

= CA$62.7

dcf — TSX:ACO.X Discounted Cash Flow January 27th 2025

Important Assumptions

We would point out 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 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 ATCO 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 5.6%, which is based on a levered beta of 0.800. 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 ATCO

Strength

Dividends are covered by earnings and cash flows.

Weakness

Earnings declined over the past year.

Interest payments on debt are not well covered.

Dividend is low compared to the top 25% of dividend payers in the Integrated Utilities market.

Opportunity

Annual revenue is forecast to grow faster than the Canadian market.

Trading below our estimate of fair value by more than 20%.

Significant insider buying over the past 3 months.

Threat

Debt is not well covered by operating cash flow.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price sitting below the intrinsic value? For ATCO, we've put together three important aspects you should further examine:

Risks: For instance, we've identified 1 warning sign for ATCO that you should be aware of.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ACO.X's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.