An Intrinsic Calculation For Tourmaline Oil Corp. (TSE:TOU) Suggests It's 40% Undervalued

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Tourmaline Oil fair value estimate is CA$105

• Tourmaline Oil is estimated to be 40% undervalued based on current share price of CA$62.34

• Analyst price target for TOU is CA$81.53 which is 22% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Tourmaline Oil Corp. (TSE:TOU) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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 Tourmaline Oil

Crunching The Numbers

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. 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$1.89b	CA$2.39b	CA$2.30b	CA$2.25b	CA$2.23b	CA$2.23b	CA$2.24b	CA$2.26b	CA$2.29b	CA$2.33b
Growth Rate Estimate Source	Analyst x6	Analyst x3	Est @ -3.77%	Est @ -2.06%	Est @ -0.86%	Est @ -0.03%	Est @ 0.56%	Est @ 0.97%	Est @ 1.26%	Est @ 1.46%
Present Value (CA$, Millions) Discounted @ 7.4%	CA$1.8k	CA$2.1k	CA$1.9k	CA$1.7k	CA$1.6k	CA$1.5k	CA$1.4k	CA$1.3k	CA$1.2k	CA$1.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$15b

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 7.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$2.3b× (1 + 1.9%) ÷ (7.4%– 1.9%) = CA$44b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$44b÷ ( 1 + 7.4%)¹⁰= CA$21b

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$37b. 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$62.3, the company appears quite undervalued at a 40% 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.

TSX:TOU Discounted Cash Flow January 16th 2024

Important 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. 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 Tourmaline 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 7.4%, which is based on a levered beta of 1.090. 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 Tourmaline Oil

Strength

• Debt is not viewed as a risk.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

• Shareholders have been diluted in the past year.

Opportunity

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

• Good value based on P/E ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• Dividends are not covered by cash flow.

• Revenue is forecast to grow slower than 20% per year.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Tourmaline Oil, there are three pertinent items you should assess:

1. Risks: Every company has them, and we've spotted 3 warning signs for Tourmaline Oil you should know about.

2. Future Earnings: How does TOU'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 TSX 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.