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Is Canadian Tire Corporation, Limited (TSE:CTC.A) Trading At A 44% Discount?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Canadian Tire Corporation, Limited (TSE:CTC.A) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Canadian Tire

Crunching the numbers

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 are 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.

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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) estimate

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

Levered FCF (CA$, Millions)

CA$667

CA$753

CA$821

CA$878

CA$925

CA$966

CA$1.0k

CA$1.0k

CA$1.1k

CA$1.1k

Growth Rate Estimate Source

Analyst x3

Analyst x3

Est @ 9.05%

Est @ 6.92%

Est @ 5.43%

Est @ 4.38%

Est @ 3.65%

Est @ 3.14%

Est @ 2.78%

Est @ 2.53%

Present Value (CA$, Millions) Discounted @ 7.3%

CA$621

CA$654

CA$665

CA$662

CA$651

CA$633

CA$611

CA$588

CA$563

CA$538

Present Value of 10-year Cash Flow (PVCF)= CA$6.19b

"Est" = FCF growth rate estimated by Simply Wall St

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (1.9%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.3%.

Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = CA$1.1b × (1 + 1.9%) ÷ (7.3% – 1.9%) = CA$21b

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = CA$CA$21b ÷ ( 1 + 7.3%)10 = CA$10.25b

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$16.43b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of CA$266.03. Compared to the current share price of CA$149.55, the company appears quite undervalued at a 44% discount to what it is available for right now. DCFs 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:CTC.A Intrinsic value, April 19th 2019
TSX:CTC.A Intrinsic value, April 19th 2019

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 Canadian Tire 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 7.3%, which is based on a levered beta of 0.898. 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.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price to differ from the intrinsic value? For Canadian Tire, I've put together three important aspects you should further research:

  1. Financial Health: Does CTC.A have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

  2. Future Earnings: How does CTC.A'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.

  3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of CTC.A? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every CA stock every day, so if you want to find the intrinsic value of any other stock just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.