A Look At The Intrinsic Value Of Advantage Energy Ltd. (TSE:AAV)

Key Insights

• The projected fair value for Advantage Energy is CA$10.50 based on 2 Stage Free Cash Flow to Equity
• Advantage Energy's CA$9.63 share price indicates it is trading at similar levels as its fair value estimate
• The CA$13.55 analyst price target for AAV is 29% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Advantage Energy Ltd. (TSE:AAV) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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 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.

See our latest analysis for Advantage Energy

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. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CA$, Millions)	CA$249.3m	CA$163.0m	CA$131.0m	CA$113.5m	CA$103.6m	CA$98.0m	CA$94.9m	CA$93.4m	CA$93.0m	CA$93.3m
Growth Rate Estimate Source	Analyst x3	Analyst x1	Analyst x1	Est @ -13.37%	Est @ -8.71%	Est @ -5.44%	Est @ -3.15%	Est @ -1.55%	Est @ -0.43%	Est @ 0.35%
Present Value (CA$, Millions) Discounted @ 7.6%	CA$232	CA$141	CA$105	CA$84.8	CA$71.9	CA$63.2	CA$56.9	CA$52.1	CA$48.2	CA$45.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$900m

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 (2.2%) 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 7.6%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CA$93m× (1 + 2.2%) ÷ (7.6%– 2.2%) = CA$1.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$1.8b÷ ( 1 + 7.6%)¹⁰= CA$854m

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$1.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA$9.6, the company appears about fair value at a 8.3% 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.

The 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 Advantage Energy 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 7.6%, which is based on a levered beta of 1.307. 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 Advantage Energy

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. For Advantage Energy, we've put together three further factors you should further examine:

1. Risks: Every company has them, and we've spotted 3 warning signs for Advantage Energy (of which 1 shouldn't be ignored!) you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for AAV'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.