Does the March share price for Diversified Royalty Corp. (TSE:DIV) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it's not too difficult to follow, as you'll see from our example!
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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (CA$, Millions)
CA$49.3m
CA$50.8m
CA$52.1m
CA$55.5m
CA$57.4m
CA$59.2m
CA$60.8m
CA$62.5m
CA$64.1m
CA$65.7m
Growth Rate Estimate Source
Analyst x1
Analyst x1
Analyst x1
Analyst x1
Est @ 3.39%
Est @ 3.08%
Est @ 2.87%
Est @ 2.71%
Est @ 2.61%
Est @ 2.53%
Present Value (CA$, Millions) Discounted @ 8.3%
CA$45.5
CA$43.3
CA$41.0
CA$40.3
CA$38.5
CA$36.6
CA$34.8
CA$33.0
CA$31.3
CA$29.6
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CA$374m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 8.3%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$1.1b÷ ( 1 + 8.3%)10= CA$509m
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$883m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$2.8, the company appears quite undervalued at a 47% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
TSX:DIV Discounted Cash Flow March 2nd 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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Diversified Royalty 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 8.3%, which is based on a levered beta of 1.375. 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 Diversified Royalty
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings.
Dividend is in the top 25% of dividend payers in the market.
Weakness
No major weaknesses identified for DIV.
Opportunity
Annual earnings are forecast to grow for the next 2 years.
Trading below our estimate of fair value by more than 20%.
Threat
Debt is not well covered by operating cash flow.
Dividends are not covered by earnings.
Annual earnings are forecast to grow slower than the Canadian market.
Moving On:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. Why is the intrinsic value higher than the current share price? For Diversified Royalty, there are three additional elements you should consider:
Risks: Take risks, for example - Diversified Royalty has 2 warning signs we think you should be aware of.
Future Earnings: How does DIV'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.
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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks 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.
