Are Investors Undervaluing CECO Environmental Corp. (NASDAQ:CECO) By 47%?

Key Insights

• The projected fair value for CECO Environmental is US$49.94 based on 2 Stage Free Cash Flow to Equity

• CECO Environmental is estimated to be 47% undervalued based on current share price of US$26.45

• Analyst price target for CECO is US$27.67 which is 45% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of CECO Environmental Corp. (NASDAQ:CECO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for CECO Environmental

The Calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$31.7m	US$54.8m	US$66.9m	US$75.0m	US$81.8m	US$87.7m	US$92.6m	US$97.0m	US$100.9m	US$104.4m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Est @ 12.05%	Est @ 9.15%	Est @ 7.12%	Est @ 5.70%	Est @ 4.70%	Est @ 4.01%	Est @ 3.52%
Present Value ($, Millions) Discounted @ 6.9%	US$29.6	US$47.9	US$54.8	US$57.4	US$58.6	US$58.7	US$58.1	US$56.9	US$55.3	US$53.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$531m

The second stage is also known as Terminal Value, this is the business's cash flow 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 have used the 5-year average of the 10-year government bond yield (2.4%) 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 6.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$104m× (1 + 2.4%) ÷ (6.9%– 2.4%) = US$2.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$2.4b÷ ( 1 + 6.9%)¹⁰= US$1.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$1.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$26.5, the company appears quite undervalued at a 47% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

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 CECO Environmental 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 6.9%, which is based on a levered beta of 0.983. 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 CECO Environmental

Strength

• Debt is well covered by cash flow.

Weakness

• Earnings declined over the past year.

• Interest payments on debt are not well covered.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Trading below our estimate of fair value by more than 20%.

• Significant insider buying over the past 3 months.

Threat

• Annual revenue is forecast to grow slower than the American market.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. Can we work out why the company is trading at a discount to intrinsic value? For CECO Environmental, we've compiled three pertinent factors you should further research:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with CECO Environmental , and understanding these should be part of your investment process.

2. Future Earnings: How does CECO'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS 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