Canacol Energy's estimated fair value is CA$7.15 based on 2 Stage Free Cash Flow to Equity
Canacol Energy's CA$6.85 share price indicates it is trading at similar levels as its fair value estimate
The US$9.10 analyst price target for CNE is 27% more than our estimate of fair value
In this article we are going to estimate the intrinsic value of Canacol Energy Ltd (TSE:CNE) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Is Canacol Energy Fairly Valued?
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
Levered FCF ($, Millions)
Growth Rate Estimate Source
Est @ -34.29%
Est @ -23.42%
Est @ -15.82%
Est @ -10.49%
Est @ -6.77%
Est @ -4.16%
Est @ -2.33%
Present Value ($, Millions) Discounted @ 12%
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$138m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 12%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$13m× (1 + 1.9%) ÷ (12%– 1.9%) = US$128m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$128m÷ ( 1 + 12%)10= US$42m
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$179m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$6.9, the company appears about fair value at a 4.2% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Canacol Energy 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 12%, which is based on a levered beta of 2.000. 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 Canacol Energy
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings and cashflows.
Dividend is in the top 25% of dividend payers in the market.
No major weaknesses identified for CNE.
Good value based on P/E ratio and estimated fair value.
Paying a dividend but company has no free cash flows.
Annual earnings are forecast to decline for the next 3 years.
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. It's not possible to obtain a foolproof valuation with a DCF model. 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Canacol Energy, we've compiled three essential factors you should further examine:
Risks: For example, we've discovered 4 warning signs for Canacol Energy (2 are a bit unpleasant!) that you should be aware of before investing here.
Future Earnings: How does CNE'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.
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. 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.