Canadian National Railway Company (TSE: CN) Embedded Value Estimate
Today we are going to do a simple walkthrough of a valuation method used to estimate the attractiveness of the Canadian National Railway Company (TSE:CNR) as an investment opportunity by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. 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 analysis template.
Check out our latest analysis for Canadian National Railways
What is the estimated valuation?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF (CA$, Millions) | 4.37 billion Canadian dollars | 4.70 billion Canadian dollars | 4.77 billion Canadian dollars | 4.85 billion Canadian dollars | 4.92 billion Canadian dollars | C$5.00 billion | C$5.08 billion | 5.16 billion Canadian dollars | 5.25 billion Canadian dollars | 5.33 billion Canadian dollars |
Growth rate estimate Source | Analyst x11 | Analyst x4 | Analyst x1 | Is at 1.54% | Is at 1.57% | Is at 1.59% | Is at 1.6% | Is at 1.61% | Is at 1.62% | Is at 1.62% |
Present value (CA$, millions) discounted at 5.9% | CA$4.1k | CA$4.2k | CA$4,000 | CA$3.9k | CA$3.7k | CA$3.6k | CA$3.4k | CA$3.3k | CA$3.1k | CA$3,000 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = 36 billion Canadian dollars
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.6%. We discount terminal cash flows to present value at a cost of equity of 5.9%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = C$5.3 billion × (1 + 1.6%) ÷ (5.9%–1.6%) = C$128 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= C$128 billion ( 1 + 5.9%)^{ten}= 72 billion Canadian dollars
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is C$109 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of C$146, the company appears to be about fair value at a 7.1% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The hypotheses
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with 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 consider Canadian National Railway 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 the debt. In this calculation, we used 5.9%, which is based on a leveraged beta of 0.998. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Next steps:
Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For Canadian National Railways, there are three additional elements you should assess:
- Risks: You should be aware of the 1 warning sign for Canadian National Railways we found out before considering an investment in the business.
- Management: Did insiders increase their shares to take advantage of market sentiment about CNR’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for each stock on the TSX every day. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.