Is Africa Oil Corp. (TSE:AOI) Trading At A 39% Discount?
Key Insights
The projected fair value for Africa Oil is CA$4.25 based on 2 Stage Free Cash Flow to Equity
Africa Oil's CA$2.60 share price signals that it might be 39% undervalued
Industry average discount to fair value of 21% suggests Africa Oil's peers are currently trading at a lower discount
In this article we are going to estimate the intrinsic value of Africa Oil Corp. (TSE:AOI) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
See our latest analysis for Africa Oil
What's The Estimated Valuation?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$158.0m | US$124.0m | US$105.5m | US$95.0m | US$89.0m | US$85.6m | US$83.7m | US$83.0m | US$82.9m | US$83.4m |
Growth Rate Estimate Source | Analyst x2 | Analyst x2 | Est @ -14.96% | Est @ -9.89% | Est @ -6.35% | Est @ -3.86% | Est @ -2.13% | Est @ -0.91% | Est @ -0.06% | Est @ 0.54% |
Present Value ($, Millions) Discounted @ 7.6% | US$147 | US$107 | US$84.8 | US$71.0 | US$61.8 | US$55.3 | US$50.3 | US$46.3 | US$43.1 | US$40.3 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$707m
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 (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 7.6%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$83m× (1 + 1.9%) ÷ (7.6%– 1.9%) = US$1.5b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.5b÷ ( 1 + 7.6%)10= US$730m
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$1.4b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$2.6, the company appears quite undervalued at a 39% discount to where the stock price trades currently. 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.
Important 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 Africa Oil 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 7.6%, which is based on a levered beta of 1.125. 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 Africa Oil
Strength
Currently debt free.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.
Opportunity
Expected to breakeven next year.
Trading below our estimate of fair value by more than 20%.
Significant insider buying over the past 3 months.
Threat
Paying a dividend but company is unprofitable.
Looking Ahead:
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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Africa Oil, there are three important aspects you should consider:
Risks: As an example, we've found 2 warning signs for Africa Oil that you need to consider before investing here.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AOI's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock 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.
