Does the September share price for Roots Corporation (TSE:ROOT) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (CA$, Millions)
CA$19.2m
CA$17.7m
CA$16.8m
CA$16.3m
CA$16.1m
CA$16.0m
CA$16.1m
CA$16.2m
CA$16.4m
CA$16.6m
Growth Rate Estimate Source
Est @ -11.98%
Est @ -7.83%
Est @ -4.92%
Est @ -2.89%
Est @ -1.46%
Est @ -0.47%
Est @ 0.23%
Est @ 0.72%
Est @ 1.06%
Est @ 1.30%
Present Value (CA$, Millions) Discounted @ 9.3%
CA$17.6
CA$14.8
CA$12.9
CA$11.5
CA$10.3
CA$9.4
CA$8.6
CA$8.0
CA$7.4
CA$6.8
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CA$107m
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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 9.3%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$228m÷ ( 1 + 9.3%)10= CA$94m
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$201m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$2.9, the company appears quite good value at a 42% 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.
TSX:ROOT Discounted Cash Flow September 10th 2023
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 Roots 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 9.3%, which is based on a levered beta of 1.483. 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 Roots
Strength
Debt is well covered by cash flow.
Weakness
Earnings declined over the past year.
Interest payments on debt are not well covered.
Opportunity
Trading below our estimate of fair value by more than 20%.
Significant insider buying over the past 3 months.
Threat
No apparent threats visible for ROOT.
Looking Ahead:
Whilst important, the DCF calculation is only one of many factors that you need to assess for 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 Roots, we've compiled three essential elements you should further research:
Risks: We feel that you should assess the 2 warning signs for Roots we've flagged before making an investment in the company.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ROOT'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.
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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.
