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Consolidated Water Co. Ltd.'s (NASDAQ:CWCO) Intrinsic Value Is Potentially 40% Above Its Share Price

Key Insights

  • The projected fair value for Consolidated Water is US$25.71 based on 2 Stage Free Cash Flow to Equity

  • Consolidated Water is estimated to be 28% undervalued based on current share price of US$18.39

  • The average premium for Consolidated Water's competitorsis currently 102%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Consolidated Water Co. Ltd. (NASDAQ:CWCO) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Consolidated Water

Is Consolidated Water Fairly Valued?

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. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF ($, Millions)

US$18.1m

US$18.9m

US$19.6m

US$20.2m

US$20.8m

US$21.3m

US$21.9m

US$22.4m

US$22.9m

US$23.4m

Growth Rate Estimate Source

Est @ 5.23%

Est @ 4.29%

Est @ 3.64%

Est @ 3.18%

Est @ 2.86%

Est @ 2.63%

Est @ 2.48%

Est @ 2.37%

Est @ 2.29%

Est @ 2.24%

Present Value ($, Millions) Discounted @ 6.9%

US$16.9

US$16.5

US$16.0

US$15.5

US$14.9

US$14.3

US$13.7

US$13.2

US$12.6

US$12.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$146m

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 6.9%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$23m× (1 + 2.1%) ÷ (6.9%– 2.1%) = US$503m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$503m÷ ( 1 + 6.9%)10= US$259m

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$405m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$18.4, the company appears a touch undervalued at a 28% 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
dcf

Important Assumptions

Now 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 Consolidated Water 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 0.800. 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.

SWOT Analysis for Consolidated Water

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Dividend is low compared to the top 25% of dividend payers in the Water Utilities market.

  • Shareholders have been diluted in the past year.

Opportunity

  • Annual earnings are forecast to grow for the next 2 years.

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

Threat

  • No apparent threats visible for CWCO.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Consolidated Water, we've compiled three additional aspects you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Consolidated Water , and understanding it should be part of your investment process.

  2. Future Earnings: How does CWCO'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 NASDAQGS every day. If you want to find the calculation for other stocks just search here.

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

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.

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