Calculating The Fair Value Of HEXO Corp. (TSE:HEXO)

Today we will run through one way of estimating the intrinsic value of HEXO Corp. ( TSE:HEXO ) by taking the expected future cash flows and discounting them to their present value. This will be done using 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model .

See our latest analysis for HEXO

The calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years.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,so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CA$, Millions)	-CA$25.5m	-CA$22.5m	-CA$744.5k	CA$3.56m	CA$21.0m	CA$37.7m	CA$58.8m	CA$82.1m	CA$105.3m	CA$126.6m
Growth Rate Estimate Source	Analyst x6	Analyst x5	Analyst x2	Analyst x2	Analyst x1	Est @ 79.38%	Est @ 56.03%	Est @ 39.68%	Est @ 28.24%	Est @ 20.23%
Present Value (CA$, Millions) Discounted @ 5.7%	-CA$24.1	-CA$20.2	-CA$0.6	CA$2.9	CA$15.9	CA$27.0	CA$39.8	CA$52.6	CA$63.8	CA$72.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$229m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period.The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 5.7%.

Terminal Value (TV) = FCF ₂₀₃₀ × (1 + g) ÷ (r – g) = CA$127m× (1 + 1.5%) ÷ (5.7%– 1.5%) = CA$3.1b

Present Value of Terminal Value (PVTV) = TV / (1 + r) ¹⁰ = CA$3.1b÷ ( 1 + 5.7%) ¹⁰ = CA$1.8b

The total value, or equity value, is then the sum of the present value of the future cash flows,which in this case is CA$2.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$5.5, the company appears reasonably undervalued at a discount of over 50%. For me this isn't a good thing, we should try and work out why the stock appears cheap in this model. Do the inputs we've used seem reasonable? Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 HEXO 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 5.7%, 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and itshouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?"If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value?For HEXO, there are threepertinentelementsyou should look at:

1. Risks : Be aware that HEXO is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

2. Future Earnings : How does HEXO's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart .

3. Other Solid Businesses : Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock justsearch here .

This article by Simply Wall St is general in nature. 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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