The intrinsic value of Fortuna Silver Mines Inc. (TSE: FVI) is potentially 83% higher than its price per share
Does Fortuna Silver Mines Inc. (TSE: FVI) share price in May reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by taking the company’s expected future cash flows and discounting them to present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are easy enough to follow.
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
Check out our latest review for Fortuna Silver Mines
We use what is called a 2-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
Typically, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) forecast
|Levered FCF ($, million)||USD 137.7 million||$ 171.3 million||$ 259.0 million||$ 193.0 million||USD 157.7 million||USD 138.2 million||$ 126.9 million||$ 120.2 million||$ 116.3 million||114.2 million USD|
|Source of estimated growth rate||Analyst x3||Analyst x4||Analyst x2||Analyst x1||Is at -18.31%||Is at -12.36%||Is @ -8.19%||Is at -5.27%||Is at -3.23%||Is at -1.8%|
|Present value (in millions of dollars) discounted at 6.8%||US $ 129||US $ 150||US $ 213||US $ 148||US $ 113||US $ 93.1||$ 80.0||$ 71.0||$ 64.3||US $ 59.1|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 1.1 billion USD
The second stage is also known as terminal value, it is the cash flow of the business after 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 used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.8%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = $ 114 million × (1 + 1.5%) ÷ (6.8% – 1.5%) = $ 2.2 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= USD 2.2 billion ÷ (1 + 6.8%)ten= 1.1 billion USD
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 2.3 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current C $ 8.0 share price, the company appears to be quite undervalued at a 45% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Fortuna Silver Mines 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 into account debt. In this calculation, we used 6.8%, which is based on a leveraged beta of 1.117. Beta is a measure of the volatility of a stock, relative 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.
While important, the DCF calculation ideally won’t be the only analysis you look at for a business. The DCF model is not a perfect inventory valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value greater than the current share price? For Fortuna Silver Mines, we have compiled three essentials that you need to evaluate:
- Risks: To this end, you should inquire about the 2 warning signs we spotted with Fortuna Silver Mines (including 1 which is potentially serious).
- Future income: How does FVI’s growth rate compare to its peers and the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow valuation for each share listed on the TSX. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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