Key Insights
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Diversified Royalty's estimated fair value is CA$5.39 based on 2 Stage Free Cash Flow to Equity
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Diversified Royalty is estimated to be 48% undervalued based on current share price of CA$2.81
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Price target $3.99 which is 26% below our fair value estimate
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Diversified Royalty Corp. (TSE:DIV) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios.
The Calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
| | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 |
| Levered FCF (CA$, Millions) | CA$39.9m | CA$41.7m | CA$45.6m | CA$48.0m | CA$49.9m | CA$51.5m | CA$52.9m | CA$54.3m | CA$55.6m | CA$56.8m |
| Growth Rate Estimate Source | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Est @ 3.86% | Est @ 3.26% | Est @ 2.84% | Est @ 2.55% | Est @ 2.34% | Est @ 2.20% |
| Present Value (CA$, Millions) Discounted @ 7.9% | CA$37.0 | CA$35.8 | CA$36.3 | CA$35.4 | CA$34.1 | CA$32.6 | CA$31.1 | CA$29.5 | CA$28.0 | CA$26.5 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$326m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 have used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.9%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CA$57m× (1 + 1.9%) ÷ (7.9%– 1.9%) = CA$955m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$955m÷ ( 1 + 7.9%)10= CA$446m
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$772m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$2.8, the company appears quite undervalued at a 48% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
dcf
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Diversified Royalty 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 7.9%, which is based on a levered beta of 1.211. 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.
SWOT Analysis for Diversified Royalty
Strength
Weakness
Opportunity
Threat