Is Exchange Income Corporation (TSE:EIF) Trading At A 28% Discount?

Key Insights

• The projected fair value for Exchange Income is CA$63.60 based on 2 Stage Free Cash Flow to Equity

• Exchange Income is estimated to be 28% undervalued based on current share price of CA$46.00

• Our fair value estimate is similar to Exchange Income's analyst price target of CA$63.75

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Exchange Income Corporation (TSE:EIF) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Exchange Income

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	-CA$107.9m	CA$218.1m	CA$216.6m	CA$217.0m	CA$218.6m	CA$221.1m	CA$224.2m	CA$227.9m	CA$231.9m	CA$236.2m
Growth Rate Estimate Source	Analyst x1	Analyst x4	Analyst x1	Est @ 0.17%	Est @ 0.74%	Est @ 1.14%	Est @ 1.42%	Est @ 1.62%	Est @ 1.76%	Est @ 1.86%
Present Value (CA$, Millions) Discounted @ 8.1%	-CA$99.8	CA$187	CA$171	CA$159	CA$148	CA$138	CA$130	CA$122	CA$115	CA$108

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$236m× (1 + 2.1%) ÷ (8.1%– 2.1%) = CA$4.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$4.0b÷ ( 1 + 8.1%)¹⁰= CA$1.8b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$3.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$46.0, the company appears a touch undervalued at a 28% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The 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. 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 Exchange Income 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 8.1%, which is based on a levered beta of 1.313. 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 Exchange Income

Strength

• Debt is well covered by cash flow.

Weakness

• Earnings growth over the past year underperformed the Airlines industry.

• Interest payments on debt are not well covered.

• Dividend is low compared to the top 25% of dividend payers in the Airlines market.

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Canadian market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Dividends are not covered by earnings.

• Revenue is forecast to grow slower than 20% per year.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Exchange Income, there are three pertinent elements you should assess:

1. Risks: Case in point, we've spotted 3 warning signs for Exchange Income you should be aware of, and 2 of them shouldn't be ignored.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for EIF's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.