Paramount Resources Ltd.'s (TSE:POU) Intrinsic Value Is Potentially 20% Below Its Share Price

Key Insights

• The projected fair value for Paramount Resources is CA$23.95 based on 2 Stage Free Cash Flow to Equity

• Paramount Resources is estimated to be 25% overvalued based on current share price of CA$29.99

• Paramount Resources' peers are currently trading at a discount of 26% on average

Does the February share price for Paramount Resources Ltd. (TSE:POU) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present 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!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Paramount Resources

The Model

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$240.0m	CA$285.7m	CA$241.0m	CA$216.1m	CA$201.8m	CA$193.6m	CA$189.3m	CA$187.4m	CA$187.3m	CA$188.3m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Est @ -10.33%	Est @ -6.64%	Est @ -4.05%	Est @ -2.24%	Est @ -0.97%	Est @ -0.08%	Est @ 0.54%
Present Value (CA$, Millions) Discounted @ 7.0%	CA$224	CA$249	CA$197	CA$165	CA$144	CA$129	CA$118	CA$109	CA$102	CA$95.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.5b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$188m× (1 + 2.0%) ÷ (7.0%– 2.0%) = CA$3.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.8b÷ ( 1 + 7.0%)¹⁰= CA$1.9b

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$3.5b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$30.0, the company appears slightly overvalued at the time of writing. 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 Paramount 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 7.0%, which is based on a levered beta of 1.095. 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 Paramount Resources

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year is below its 5-year average.

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

Opportunity

• Annual earnings are forecast to grow for the next 4 years.

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• No apparent threats visible for POU.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. What is the reason for the share price exceeding the intrinsic value? For Paramount Resources, we've put together three essential elements you should further examine:

1. Risks: Every company has them, and we've spotted 2 warning signs for Paramount Resources you should know about.

2. Future Earnings: How does POU'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. 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.