Do investors undervalue Champion Iron Limited (ASX: CIA) by 49%?
How far is Champion Iron Limited (ASX: CIA) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking expected future cash flows and discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
See our latest review for Champion Iron
We’re going to use a two-stage 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.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
|Leverage FCF (C $, Millions)||CAN $ 226.0 million||CAN $ 357.3 million||C $ 451.2 million||$ 441.8 million Canadian||CAD 296.0 million||CAN $ 287.3 million||CAN $ 283.1 million||CAN $ 281.8 million||CAN $ 282.5 million||CAN $ 284.7 million|
|Source of estimated growth rate||Analyst x6||Analyst x5||Analyst x4||Analyst x3||Analyst x2||East @ -2.92%||Is @ -1.47%||East @ -0.45%||Is @ 0.26%||East @ 0.76%|
|Present value (CA $, millions) discounted at 7.1%||CA $ 211||CA $ 312||CA $ 368||CA $ 336||CA $ 210||CA $ 191||CA $ 176||CA $ 163||CA $ 153||$ 144 CAD|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CA $ 2.3 billion
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. 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 1.9%. We discount the terminal cash flows to their present value at a cost of equity of 7.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA $ 285 million × (1 + 1.9%) ÷ (7.1% – 1.9%) = CA $ 5.6 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= CA $ 5.6 billion ÷ (1 + 7.1%)ten= CA $ 2.9 billion
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is C $ 5.1 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of AU $ 5.5, the company appears to be quite undervalued with a 49% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 complete picture of a company’s potential performance. Since we view Champion Iron 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 debt into account. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.089. 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 ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect equity valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value greater than the current share price? For Champion Iron, there are three additional items you should be looking at:
- Risks: You should be aware of the 4 warning signs for Champion Iron (2 cannot be ignored!) We found out before considering an investment in the business.
- Future benefits: How does CIA’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- 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 might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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