Is There An Opportunity With Whitecap Resources Inc.'s (TSE:WCP) 25% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Whitecap Resources fair value estimate is CA$11.57

• Whitecap Resources' CA$8.73 share price signals that it might be 25% undervalued

• When compared to theindustry average discount to fair value of 25%, Whitecap Resources' competitors seem to be trading at a greater discount

How far off is Whitecap Resources Inc. (TSE:WCP) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ 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 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 Whitecap Resources

The Model

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, 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$547.3m	CA$689.2m	CA$575.9m	CA$512.9m	CA$476.7m	CA$455.8m	CA$444.5m	CA$439.4m	CA$438.4m	CA$440.2m
Growth Rate Estimate Source	Analyst x6	Analyst x5	Est @ -16.44%	Est @ -10.93%	Est @ -7.07%	Est @ -4.37%	Est @ -2.48%	Est @ -1.16%	Est @ -0.23%	Est @ 0.42%
Present Value (CA$, Millions) Discounted @ 8.0%	CA$507	CA$591	CA$458	CA$377	CA$325	CA$288	CA$260	CA$238	CA$220	CA$204

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.5b

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 8.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$440m× (1 + 1.9%) ÷ (8.0%– 1.9%) = CA$7.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$7.4b÷ ( 1 + 8.0%)¹⁰= CA$3.4b

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$6.9b. 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$8.7, the company appears a touch undervalued at a 25% 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.

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. 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 Whitecap 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 8.0%, which is based on a levered beta of 1.208. 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 Whitecap Resources

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

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

Weakness

• Earnings declined over the past year.

Opportunity

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

• Significant insider buying over the past 3 months.

Threat

• No apparent threats visible for WCP.

Next Steps:

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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Whitecap Resources, we've put together three pertinent aspects you should further research:

1. Risks: Every company has them, and we've spotted 2 warning signs for Whitecap Resources (of which 1 is a bit unpleasant!) you should know about.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for WCP'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.

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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.