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Is There An Opportunity With Parex Resources Inc.'s (TSE:PXT) 50% Undervaluation?

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Parex Resources fair value estimate is CA$53.93

  • Parex Resources is estimated to be 50% undervalued based on current share price of CA$27.06

  • Industry average discount to fair value of 21% suggests Parex Resources' peers are currently trading at a lower discount

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Parex Resources Inc. (TSE:PXT) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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. 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 Parex Resources

Is Parex Resources 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. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF ($, Millions)

US$372.7m

US$359.6m

US$292.4m

US$270.0m

US$257.1m

US$250.0m

US$246.6m

US$245.7m

US$246.5m

US$248.5m

Growth Rate Estimate Source

Analyst x6

Analyst x6

Analyst x2

Est @ -7.66%

Est @ -4.78%

Est @ -2.77%

Est @ -1.36%

Est @ -0.37%

Est @ 0.32%

Est @ 0.80%

Present Value ($, Millions) Discounted @ 7.5%

US$347

US$311

US$235

US$202

US$179

US$162

US$148

US$137

US$128

US$120

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.0b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 7.5%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$248m× (1 + 1.9%) ÷ (7.5%– 1.9%) = US$4.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$4.5b÷ ( 1 + 7.5%)10= US$2.2b

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 US$4.1b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$27.1, the company appears quite good value at a 50% 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
dcf

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 Parex Resources 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 7.5%, which is based on a levered beta of 1.123. 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 Parex Resources

Strength

  • Earnings growth over the past year exceeded the industry.

  • Currently debt free.

Weakness

  • Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.

Opportunity

  • Trading below our estimate of fair value by more than 20%.

Threat

  • Paying a dividend but company has no free cash flows.

Next Steps:

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. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Parex Resources, we've compiled three relevant elements you should look at:

  1. Risks: For example, we've discovered 3 warning signs for Parex Resources (1 doesn't sit too well with us!) that you should be aware of before investing here.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PXT's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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. 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.

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.

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