Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Calfrac Well Services Ltd. (TSE:CFW) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (CA$, Millions)
CA$61.0m
CA$53.3m
CA$49.0m
CA$46.6m
CA$45.3m
CA$44.8m
CA$44.7m
CA$44.9m
CA$45.4m
CA$46.0m
Growth Rate Estimate Source
Analyst x3
Analyst x3
Est @ -8.00%
Est @ -4.92%
Est @ -2.76%
Est @ -1.25%
Est @ -0.20%
Est @ 0.54%
Est @ 1.06%
Est @ 1.42%
Present Value (CA$, Millions) Discounted @ 10%
CA$55.3
CA$43.8
CA$36.5
CA$31.5
CA$27.7
CA$24.8
CA$22.4
CA$20.4
CA$18.7
CA$17.2
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CA$298m
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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 10%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$584m÷ ( 1 + 10%)10= CA$218m
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$517m. 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$3.8, the company appears quite undervalued at a 36% 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:CFW Discounted Cash Flow December 8th 2024
Important Assumptions
Now 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 Calfrac Well Services 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 10%, which is based on a levered beta of 1.958. 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 Calfrac Well Services
Strength
Debt is well covered by cash flow.
Weakness
Earnings declined over the past year.
Interest payments on debt are not well covered.
Shareholders have been diluted in the past year.
Opportunity
Annual earnings are forecast to grow faster than the Canadian market.
Good value based on P/E ratio and estimated fair value.
Significant insider buying over the past 3 months.
Threat
Annual revenue is forecast to grow slower than the Canadian market.
Next Steps:
Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. What is the reason for the share price sitting below the intrinsic value? For Calfrac Well Services, there are three essential items you should consider:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CFW'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.
