How far is WSP Global Inc. (TSE:WSP) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking the expected future cash flows and discounting them to the present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.

See our latest analysis for WSP Global

The calculation

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:

10-Year Free Cash Flow (FCF) Forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = 7.3 billion Canadian dollars

The story continues

The second stage is also known as the terminal value, it 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 10-year government bond yield of 1.6%. We discount terminal cash flows to present value at a cost of equity of 6.2%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = C$1.3 billion × (1 + 1.6%) ÷ (6.2%–1.6%) = C$28 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= C$28B÷ ( 1 + 6.2%)^ten= 15 billion Canadian dollars

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is C$23 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of C$140, the company looks slightly undervalued at a 28% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

We emphasize 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 entries, I recommend that you redo the calculations yourself and play around with them. 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 consider WSP Global 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 6.2%, which is based on a leveraged beta of 1.088. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Can we understand why the company is trading at a discount to its intrinsic value? For WSP Global, we have put together three key aspects that you should consider in more detail:

1. Financial health: Does WSP have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.

2. Future earnings: How does WSP’s growth rate compare to that of its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.

3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app performs a daily updated cash flow valuation for each stock on the TSX. If you want to find the calculation for other stocks, 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.