Estimating the fair value of Fortis Inc. (TSE:FTS)

Key findings

• The estimated fair value of Fortis based on the dividend discount model is CA$51.20

• With a share price of CAD 56.70, Fortis appears to be trading close to its estimated fair value

• Our fair value estimate is 15% below Fortis analysts’ target price of CA$60.13.

Today we’re going to go over one way to estimate the intrinsic value of Fortis Inc. (TSE:FTS) by taking the expected future cash flows and discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we’ll use to do this. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many and is not without its flaws. For those who enjoy stock analysis, the Simply Wall St analysis model presented here might be of interest.

Check out our latest analysis for Fortis

What is the estimated value?

We need to calculate the value of Fortis a little differently than other stocks because it’s an electric utility company. Rather than using free cash flow, which is difficult to estimate and often unreported by analysts in this industry, it uses dividends per share (DPS). Unless a company pays out the majority of its free cash flow as dividends, this method will typically underestimate the value of the stock. It uses the “Gordon Growth Model,” which simply assumes that dividend payments will continue to grow at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average 10-year Treasury yield of 1.8%. We then discount that number to today’s value at a cost of equity of 6.6%. Relative to the current share price of CA$56.7, the company seems about fair at the time of writing. However, remember that this is only an approximate assessment and as with any complex formula, where garbage goes in, garbage comes out.

Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)

= CA$2.4 / (6.6% – 1.8%)

= 51.2 CA$

The assumptions

We would like to point out that the key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the calculation yourself and play with the assumptions. DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs and therefore does not provide a complete picture of a company’s potential performance. Since we consider Fortis 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 takes debt into account. In this calculation, we used 6.6%, which is based on a leveraged beta of 0.800. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT analysis for Fortis

Strength

weakness

Opportunity

Danger

Next Steps:

While a company’s valuation is important, it is only one of many factors you need to evaluate for a company. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. For example, making a small adjustment to the terminal value growth rate can dramatically change the overall result. For Fortis, we have compiled three additional points to consider:

1. Risks: We think you should 2 warning signals for Fortis (1 means potentially serious!), we marked before investing in the company.

2. management:Have insiders increased their shares to capitalize on market sentiment regarding FTS’s future prospects? Read our management and board analysis with insights into CEO compensation and governance factors.

3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS The Simply Wall St app runs 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.

Do you have feedback on this article? Are you concerned about the content? Get in touch directly from us. Alternatively, send an email to editorial-team (at) simplywallst.com.

This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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