Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Champion Iron fair value estimate is AU$8.99
• Champion Iron is estimated to be 49% undervalued based on current share price of AU$4.57
• Analyst price target for CIA is CA$6.37 which is 29% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Champion Iron Limited (ASX:CIA) 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Our free stock report includes 4 warning signs investors should be aware of before investing in Champion Iron. Read for free now.

What's The Estimated Valuation?

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 start off with, we need to estimate the next ten years of cash flows. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CA$, Millions)	-CA$298.7m	CA$192.8m	CA$419.1m	CA$418.0m	CA$354.7m	CA$320.2m	CA$301.0m	CA$290.8m	CA$286.4m	CA$285.6m
Growth Rate Estimate Source	Analyst x4	Analyst x5	Analyst x4	Analyst x3	Analyst x2	Est @ -9.74%	Est @ -5.99%	Est @ -3.37%	Est @ -1.54%	Est @ -0.26%
Present Value (CA$, Millions) Discounted @ 8.1%	-CA$276	CA$165	CA$332	CA$307	CA$241	CA$201	CA$175	CA$157	CA$143	CA$132

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.6b

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 (2.7%) 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 8.1%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CA$286m× (1 + 2.7%) ÷ (8.1%– 2.7%) = CA$5.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$5.5b÷ ( 1 + 8.1%)¹⁰= CA$2.5b

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$4.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$4.6, the company appears quite good value at a 49% 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.

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 Champion Iron 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 8.1%, which is based on a levered beta of 1.227. 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.

View our latest analysis for Champion Iron

SWOT Analysis for Champion Iron

Next Steps:

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. 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. What is the reason for the share price sitting below the intrinsic value? For Champion Iron, there are three further items you should further research:

1. Risks: To that end, you should learn about the 4 warning signs we've spotted with Champion Iron (including 1 which makes us a bit uncomfortable) .
2. Future Earnings: How does CIA'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 ASX 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.