An Intrinsic Calculation For Freehold Royalties Ltd. (TSE:FRU) Suggests It's 33% Undervalued

Key Insights

• The projected fair value for Freehold Royalties is CA$21.53 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$14.35 suggests Freehold Royalties is potentially 33% undervalued

• Our fair value estimate is 9.1% higher than Freehold Royalties' analyst price target of CA$19.73

Today we will run through one way of estimating the intrinsic value of Freehold Royalties Ltd. (TSE:FRU) by estimating the company's future cash flows and discounting them to their present 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Freehold Royalties

The Model

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. To begin with, we have to get estimates of 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.

Generally we assume that a dollar today is more valuable 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$257.1m	CA$275.5m	CA$266.7m	CA$249.2m	CA$251.7m	CA$247.1m	CA$245.2m	CA$245.2m	CA$246.6m	CA$248.9m
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x1	Analyst x1	Analyst x1	Est @ -1.84%	Est @ -0.75%	Est @ 0.01%	Est @ 0.55%	Est @ 0.93%
Present Value (CA$, Millions) Discounted @ 8.7%	CA$237	CA$233	CA$208	CA$178	CA$166	CA$150	CA$137	CA$126	CA$116	CA$108

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.7b

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 (1.8%) 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 8.7%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$249m× (1 + 1.8%) ÷ (8.7%– 1.8%) = CA$3.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.7b÷ ( 1 + 8.7%)¹⁰= CA$1.6b

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$3.2b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$14.4, the company appears quite good value at a 33% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 8.7%, which is based on a levered beta of 1.165. 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

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

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

Weakness

• No major weaknesses identified for FRU.

Opportunity

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

• Significant insider buying over the past 3 months.

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to decline for the next 2 years.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Freehold Royalties, there are three additional items you should assess:

1. Risks: For example, we've discovered 2 warning signs for Freehold Royalties (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.

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