Are Investors Undervaluing Western Energy Services Corp. (TSE:WRG) By 26%?

Key Insights

• Western Energy Services' estimated fair value is CA$4.64 based on 2 Stage Free Cash Flow to Equity

• Western Energy Services' CA$3.44 share price signals that it might be 26% undervalued

• When compared to theindustry average discount to fair value of 12%, Western Energy Services' competitors seem to be trading at a lesser discount

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Western Energy Services Corp. (TSE:WRG) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Western Energy Services

Is Western Energy Services 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$17.0m	CA$16.8m	CA$16.7m	CA$16.7m	CA$16.9m	CA$17.0m	CA$17.3m	CA$17.5m	CA$17.8m	CA$18.1m
Growth Rate Estimate Source	Analyst x2	Est @ -1.42%	Est @ -0.44%	Est @ 0.25%	Est @ 0.73%	Est @ 1.07%	Est @ 1.31%	Est @ 1.47%	Est @ 1.59%	Est @ 1.67%
Present Value (CA$, Millions) Discounted @ 12%	CA$15.2	CA$13.4	CA$11.9	CA$10.7	CA$9.6	CA$8.7	CA$7.9	CA$7.1	CA$6.5	CA$5.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$97m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$18m× (1 + 1.9%) ÷ (12%– 1.9%) = CA$184m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$184m÷ ( 1 + 12%)¹⁰= CA$60m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$157m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$3.4, the company appears a touch undervalued at a 26% 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

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Western Energy Services 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 Western Energy Services

Strength

• Debt is well covered by cash flow.

Weakness

• Interest payments on debt are not well covered.

Opportunity

• Has sufficient cash runway for more than 3 years based on current free cash flows.

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

Threat

• No apparent threats visible for WRG.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Western Energy Services, there are three important aspects you should consider:

1. Risks: For instance, we've identified 1 warning sign for Western Energy Services that you should be aware of.

2. Future Earnings: How does WRG'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 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. 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.

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.