Estimating the intrinsic value of Stelco Holdings Inc. (TSE:STLC)

Key findings

• The forecast fair value for Stelco Holdings is CA$42.54 based on the 2-step Free Cash Flow to Equity
• The current share price of CA$37.36 suggests that Stelco Holdings may be trading close to its fair value.
• Our fair value estimate is 13% below Stelco Holdings’ analyst price target of CA$49.07.

Does Stelco Holdings Inc. (TSE:STLC)’s July share price reflect its true value? Today we’ll estimate the stock’s intrinsic value by estimating the company’s future cash flows and discounting them to their present value. One way to do this is by applying the Discounted Cash Flow (DCF) model. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

Companies can be valued in many ways, so we would like to point out that a DCF is not perfect for every situation. If you want to learn more about intrinsic value, you should take a look at Simply Wall St’s analysis model.

Check out our latest analysis for Stelco Holdings

The calculation

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally speaking, the first stage is one of higher growth, and the second stage is one of lower growth. First, we need to get estimates for 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, we discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = CA$1.1 billion

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year Treasury yield of 2.1%. We discount the terminal cash flows to today’s value at a cost of equity of 8.1%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CA$162 million × (1 + 2.1%) ÷ (8.1% – 2.1%) = CA$2.7 billion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= CA$2.7 billion ÷ ( 1 + 8.1 %)¹⁰= CA$1.3 billion

The total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total value of equity, which in this case is CA$2.3 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$37.4, the company appears roughly fairly valued at a 12% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s better to consider this a rough estimate that isn’t accurate to the last cent.

Important assumptions

The above calculation heavily depends on two assumptions. The first is the discount rate and the other is the 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 are considering Stelco Holdings as prospective 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 8.1% which is based on a leveraged beta of 1.312. 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 an imposed limit of between 0.8 and 2.0 which is a reasonable range for a stable company.

SWOT Analysis for Stelco Holdings

Looking ahead:

While a company’s valuation is important, it shouldn’t be the only metric you consider when researching a company. DCF models aren’t the be-all and end-all of investment valuation. The best thing to do is apply different cases and assumptions and see how they affect the company’s valuation. If a company grows differently, or its cost of equity or risk-free rate changes significantly, the outcome could look very different. For Stelco Holdings, we’ve compiled three relevant elements that you should examine in more detail:

1. Risks: Please note that Stelco Holdings 2 warning signals in our investment analysis you should know about…
2. Future income: How does STLC’s growth rate compare to its competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.
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.

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This Simply Wall St article is of a general nature. We comment solely on the basis of 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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