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Is Freehold Royalties Ltd. (TSE:FRU) Trading At A 46% Discount?

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Freehold Royalties fair value estimate is CA$27.06

  • Current share price of CA$14.61 suggests Freehold Royalties is potentially 46% undervalued

  • Our fair value estimate is 56% higher than Freehold Royalties' analyst price target of CA$17.30

In this article we are going to estimate the intrinsic value of Freehold Royalties Ltd. (TSE:FRU) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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View our latest analysis for Freehold Royalties

Step By Step Through The Calculation

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. To start off with, we need to estimate 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (CA$, Millions)

CA$166.8m

CA$248.5m

CA$235.4m

CA$238.0m

CA$241.0m

CA$241.0m

CA$242.5m

CA$245.0m

CA$248.2m

CA$252.0m

Growth Rate Estimate Source

Analyst x4

Analyst x4

Analyst x1

Analyst x1

Analyst x1

Est @ 0.02%

Est @ 0.61%

Est @ 1.02%

Est @ 1.31%

Est @ 1.52%

Present Value (CA$, Millions) Discounted @ 7.2%

CA$156

CA$216

CA$191

CA$180

CA$170

CA$159

CA$149

CA$140

CA$133

CA$126

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.6b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 5-year average of the 10-year government bond yield (2.0%) 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 7.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CA$252m× (1 + 2.0%) ÷ (7.2%– 2.0%) = CA$4.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$4.9b÷ ( 1 + 7.2%)10= CA$2.5b

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$4.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$14.6, the company appears quite good value at a 46% 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
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. 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 Freehold Royalties 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 7.2%, which is based on a levered beta of 1.133. 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 Freehold Royalties

Strength

  • Debt is not viewed as a risk.

  • Dividend is in the top 25% of dividend payers in the market.

Weakness

  • Earnings declined over the past year.

Opportunity

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

Threat

  • Dividends are not covered by earnings.

  • Annual revenue is forecast to grow slower than the Canadian market.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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 Freehold Royalties, we've put together three relevant elements you should explore:

  1. Risks: Case in point, we've spotted 1 warning sign for Freehold Royalties you should be aware of.

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

  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.