Calculating The Fair Value Of Canopy Growth Corporation (TSE:WEED)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Canopy Growth fair value estimate is CA$8.19

• With CA$9.74 share price, Canopy Growth appears to be trading close to its estimated fair value

• The CA$8.98 analyst price target for WEED is 9.6% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Canopy Growth Corporation (TSE:WEED) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Canopy Growth

Crunching The Numbers

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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$215.8m	-CA$123.3m	-CA$74.0m	-CA$20.4m	CA$22.0m	CA$31.3m	CA$38.6m	CA$45.0m	CA$50.6m	CA$55.3m
Growth Rate Estimate Source	Analyst x3	Analyst x4	Analyst x4	Analyst x2	Analyst x2	Analyst x2	Est @ 23.09%	Est @ 16.79%	Est @ 12.37%	Est @ 9.29%
Present Value (CA$, Millions) Discounted @ 5.8%	-CA$204	-CA$110	-CA$62.5	-CA$16.3	CA$16.6	CA$22.3	CA$26.0	CA$28.7	CA$30.5	CA$31.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -CA$237m

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. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 5.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$55m× (1 + 2.1%) ÷ (5.8%– 2.1%) = CA$1.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$1.5b÷ ( 1 + 5.8%)¹⁰= CA$862m

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$624m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$9.7, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

The Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Canopy Growth 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 5.8%, which is based on a levered beta of 0.810. 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 Canopy Growth

Strength

• Debt is well covered by earnings.

Weakness

• Expensive based on P/S ratio and estimated fair value.

• Shareholders have been diluted in the past year.

Opportunity

• Forecast to reduce losses next year.

Threat

• Debt is not well covered by operating cash flow.

• Has less than 3 years of cash runway based on current free cash flow.

• Not expected to become profitable over the next 3 years.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Canopy Growth, we've compiled three pertinent factors you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Canopy Growth (at least 1 which shouldn't be ignored) , and understanding these should be part of your investment process.

2. Future Earnings: How does WEED'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts 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 article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com