Key Insights
Today we will run through one way of estimating the intrinsic value of Algonquin Power & Utilities Corp. (TSE:AQN) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward. Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you. Check out our latest analysis for Algonquin Power & Utilities The ModelAs Algonquin Power & Utilities operates in the integrated utilities sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. This often underestimates the value of a stock, but it can still be good as a comparison to competitors. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. For a number of reasons a very conservative growth rate is used that cannot exceed that of a company's Gross Domestic Product (GDP). In this case we used the 5-year average of the 10-year government bond yield (1.8%). The expected dividend per share is then discounted to today's value at a cost of equity of 6.5%. Compared to the current share price of CA$10.5, the company appears about fair value at a 17% 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. Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate) = US$0.4 / (6.5% – 1.8%) = CA$12.7 The AssumptionsThe calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Algonquin Power & Utilities 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 6.5%, which is based on a levered beta of 0.800. 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 Algonquin Power & UtilitiesStrength
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Next Steps: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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Algonquin Power & Utilities, we've compiled three fundamental aspects you should consider:
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. Valuation is complex, but we're helping make it simple.Find out whether Algonquin Power & Utilities is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health. View the Free AnalysisHave feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. |
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